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Valuing the defeasance option in securitized commercial mortgages.

Article Excerpt
To protect the interests of investors, commercial mortgage loans pooled for the issuance of commercial mortgage-backed securities (CMBS) have restrictive covenants that discourage the borrower from refinancing. Such restrictions limit the borrower's ability to access any accumulated equity. The predominant means of accessing this equity today is defeasance. By defeasing a loan, the borrower substitutes the commercial mortgage with U.S. Treasury or agency obligations whose payments match those of the defeased mortgage. Therefore, defeasance is an exchange option whereby the borrower gives up the portfolio of Treasury or agency securities and in return receives the market value of the commercial mortgage plus the liquidity benefits arising from accessing the accumulated equity in the underlying property. The value of the option to defease is shown to depend critically on the rate of return that can be earned on the released equity, prevailing interest rate conditions, as well as the option's contractual features.

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To protect commercial mortgage-backed securities (CMBS) investors, the underlying conduit loans contain covenants that restrict the borrower's ability to prepay. Ranging from lockout provisions, which completely forbid the prepayment of the loan for a specified period, to various forms of prepayment penalties, such as yield maintenance provisions, these features assure investors of a stream of uninterrupted payments. Although this call protection is beneficial to the CMBS investor, it does potentially restrict a borrower's ability to access any accumulated equity in the underlying property.

While prepayment is typically not allowed, in most conduit structures the borrower does have the option to defease the loan by replacing their mortgage in a particular mortgage pool with a portfolio of Treasury or agency securities whose payments match the mortgage's payments. (1) In fact, defeasance is now the predominant means by which commercial mortgage borrowers can access their accumulated equity. Because the payments are identical, the investors' scheduled cash flows are not interrupted. The investor benefits further because the safer Treasury securities have replaced the riskier mortgage. If sufficient pool principal is defeased, rating agencies may upgrade the bond and the bond-holder will benefit from the lower risk.

Therefore, defeasance is an exchange option whereby the borrower gives up a portfolio of Treasury or agency securities and in return receives the market value of the commercial mortgage plus the liquidity benefits arising from accessing the accumulated equity in the underlying property. The value of the option to defease is shown to depend critically on the rate of return that can be earned on the released equity and prevailing interest rate conditions as well as the option's contractual features.

Determining the value a borrower assigns to the defeasance option places an upper bound on what a lender can charge for this particular feature. How much, if anything, the borrower will actually pay depends on the nature of competition and the allocation of bargaining power between the borrower and the lender. For example, to the extent that the conduit loan market is competitive, we would not expect a lender to charge for a feature like defeasance, which is not only costless to provide but also enhances the loan's securitization.

There are important differences between prepaying residential versus commercial mortgages. In residential mortgage markets borrowers typically prepay when interest rates fall. Commercial mortgages are prepaid for different reasons. In fact, commercial mortgages are typically prepaid to take equity out of an underlying property, and this can happen if either (i) interest rates rise and the value of the mortgage falls or (ii) building values rise. (2)

The plan of this article is as follows. The second section provides background information on commercial mortgage defeasance. In the third section we detail our framework and value the option to defease. A variety of comparative static results illustrating the properties of this option are presented in the fourth section. The fifth section provides current estimates of the value of the commercial mortgage defeasance option for different underlying property types across a number of markets. We conclude in the final section.

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Background

Current estimates put the market capitalization of the CMBS market at well over $400 billion as of the end of 2002. By any measure, this is a large and growing market. For example, the size of the CMBS market is comparable to that of the credit card-backed securities market, $398 billion outstanding as of the end of 2002, and is much larger than the automobile loan-backed securities market, $222 billion outstanding as of the end of 2002.

Early conduit loans typically had a 25-year amortization schedule with a balloon payment due at the end of the 10th year. The initial years of these loans often represented a "lockout" period, typically lasting from 2 to 5 years, during which prepayment of any form is forbidden. After this period, the borrower could call the loan subject to various forms of prepayment penalties including yield maintenance clauses which require the borrower to pay an amount equal to the present value of the difference between the original schedule of payments and the new payment stream given prevailing rates. In an environment of decreasing mortgage rates, this penalty essentially eliminates the borrower's incentive to refinance. Even though this feature provides CMBS investors protection during a period of decreasing mortgage rates, it does not discourage refinancings by borrowers who wish to take advantage of equity take-out strategies, even when rates have escalated. (3)

By early 1995, some CMBS deals included loans with the option to defease as a substitute for yield maintenance. The present trend is toward the elimination of prepayment penalties and extending the lockout period, possibly for the entire term of the loan, but giving the borrower the option to defease the loan during the lockout period. As Figure 1 demonstrates, currently well over 90% of all commercial mortgages allow prepayment by defeasance. The ability to access one's equity using defeasance, however, is costly. Because the portfolio of coupon-matching government securities is riskless, it will trade at a significant premium over the mortgage. To defease, the borrower must absorb this difference. Furthermore, for loans of less than $10 million...

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