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Last December, the board of an Upper West Side co-op wanted to refinance its underlying mortgage to replenish its coffers. That was, until the directors discovered that paying off the $2.2 million loan eight months early would cost them $149,000 in fees and penalties. The building owed such a huge sum because its mortgage included a risky and rarely used prepayment penalty called defeasance.
“It was shocking to see those kinds of fees,” said Theresa Racht, a partner at Racht & Taffae and the attorney for the co-op, a prewar building on West End Avenue that wanted to replace its existing mortgage with a larger loan to pay for ongoing renovations.
Because co-op mortgages are commercial loans, they include a prepayment penalty for paying off the principal early. There are two common penalties. The first is yield maintenance, where the borrower is required to pay off the interest that remains on the loan in addition to the principal. The second is a declining prepayment, where a penalty is locked in and eases as the loan matures.
But defeasance is different. Rather than pay a set penalty, the amount due is tied to the market. And today’s market is not favorable to someone with a mortgage made nine years ago when interest rates were about six or seven percent. “Defeasance is pretty much the worst possible prepayment penalty that a co-op can have,” says Gregg Winter, president of Winter & Company, a commercial mortgage brokerage firm.
How It Works
Although defeasance is not common, many co-ops with loans made about 10 years ago through the National Cooperative Bank (NCB) have defeasance requirements. The Federal Home Loan Mortgage Corporation, better known as Freddie Mac, still offers a defeasance option in its loans. In order to pay off such a loan, the borrower must replace the principal and all the remaining interest due with a bundle of treasury bills. But treasuries are trading at a very low rate. So, a building that owes two years on a $10 million interest-only loan with a rate of six percent is going to have to buy treasuries that are trading at just 0.25 percent. In this case, the co-op would be left owing $1.15 million on top of the $10 million principal, or a total of $11.15 million.
The process is also time-consuming. Paying off, or “defeasing,” a loan takes about 30 to 45 days and involves a full three-day closing process, which means paying a group of experts – an attorney, an accountant, and a defeasance consultant – for three days of work. “It’s painful,” said John Ahern, a vice president at Commercial Defeasance, a company that handles such transactions. “Our job is to make it not painful.”
Defeasance, a common tool in the bond market, began showing up in co-op mortgages during the heady days of the real estate boom. As investment banks got into the co-op mortgage business, they began bundling the loans and securitizing them to resell to investors, just as they did with loans for single-family housing, college tuition, and municipal projects.
In order to make co-op mortgages a safe bet for investors, they added yield maintenance or defeasance clauses so the investors would be guaranteed a full return on the loan including all the interest, regardless of whether the borrower sold or refinanced the property. In turn, banks offered co-ops lower interest rates than they would have gotten for a mortgage with a less risky penalty. In a different market, where treasuries were trading at a rate closer to the interest rate on the loan, a borrower could break even or even make money off the deal.
“Everybody thinks they got a bad deal, but in reality at the time they got a great deal, but rates have gone so crazy the other way that people feel that they got ripped off,” says Thomas Schissler, who sources and originates co-op loans as managing director of Wells Fargo Multifamily Capital.
For co-ops that opted for defeasance, many boards didn’t fully understand what they were getting into. “At the time we negotiated the original mortgage nine years ago, this stuff was all there,” recalls Racht, the attorney for the West End Avenue co-op. “But the reality of it is nobody understood. They didn’t really have a handle on it, and frankly none of us had actually gone through one before.”
In some cases, the penalty has been disastrous. When a New York City co-op went to refinance its $16 million, 30-year mortgage with a defeasance clause, the building got hit with a $6.5 million prepayment penalty because it still had 20 years left on the mortgage.
The building needed to replace its heating system, a capital improvement that was going to cost $14 million. The board couldn’t afford to wait until the mortgage matured, but it also couldn’t afford the $6.5 million penalty. So the residents turned up in front of the bank’s Manhattan headquarters and staged a protest, forcing the bank to lower the penalty to $4.5 million, which was bundled into a new $40 million loan.
Defeasance “is an incredible windfall for the banks,” says James Samson, a partner in Samson, Fink & Dubow and a real estate attorney who represented the co-op.
Steps to Take
Although defeasance can be an overwhelming process, there are steps co-op boards can take to lessen the pain and avoid sticker shock.
Try to get out of it. Despite the tough rules, there can be ways around it, according to Samson. Read the paperwork. Look for a mistake or glitch in the documents that offers a borrower a way out of the penalty. “Find your loophole and drive your truck through it,” advises Samson, who says that he has read mortgage agreements that offer escape clauses from prepayment penalties.
If that doesn’t work, track down the bank or individual who holds the mortgage and see if he might be willing to allow the co-op to pay early without a penalty. Many banks, especially smaller regional ones, have liquidity problems and might be willing to let a borrower pay back a mortgage, which would improve the bank’s balance sheets. It’s a question of understanding the business needs of the mortgage-holder, asserts Samson.
Do the math. Many co-ops are eager to refinance, but defeasance adds an expensive variable to the equation. A board should ask a professional, such as a defeasance consultant or attorney, to crunch the numbers to find out exactly what refinancing would cost.
“Money is cheap now, so it’s a great opportunity to lower your debt service,” says David Lipson, director of the mortgage division at Century Operating, a property management company in New York City. “But you have to run the numbers.”
Some defeasance policies have a built-in window in the last few months of the loan where there is no penalty. By waiting, a building could save time and money, but that could mean foregoing the low interest rates. In other cases, although the penalty hurts, the building will save money in the long run by refinancing. “They’re paying these numbers because sometimes the math just works. It may hurt their feelings, but it ends well,” says Schissler of Wells Fargo.
Decide if defeasance is worth it. Freddie Mac still offers a defeasance option for co-op mortgages. Although defeasance can be a headache, the rates are generally lower than other mortgages and, with interest rates so low now, it is likely rates will be higher in 10 years when the mortgage matures, so a co-op might actually make money off the investment down the road. But before the building signs onto a mortgage with such a clause, board members should be well aware of the process involved with refinancing.
“I know people who go through a defeasance loan and say, ‘I’m never going through that again,’ but that’s not necessarily the best choice,” says Schissler.
Be prepared. Once the defeasance process is set in motion, it can quickly become difficult and costly. Long before co-op board members begin refinancing, they should discuss the work and fees involved and decide if the board members are up for the task. If they ultimately decide to defease their loan, they should assemble a team of experts to steer them through the process. For a fee, consulting firms, like Commercial Defeasance, can take the lead, coordinating with all the parties involved.
In hindsight, Racht wishes her clients on West End Avenue had walked into the process more aware of what they were facing. “I would have had them have a bigger discussion about it,” she admits. “I don’t know if I would have advised one way or another, but I certainly would have advised them to discuss it.”