How Borrowers Can Navigate Loan Cancellation Transactions
Any borrower looking to refinance an existing commercial real estate loan or sell encumbered real estate should consider how to unlock their existing financing. Commercial loan documents typically require either a prepayment premium or loan forgiveness if the borrower intends to withdraw from the loan before maturity. While most traditional loans require payment of a premium as a condition of early exit, some require the borrower to “cancel” the loan instead. Here’s a simple plan for borrowers navigating the defeasance process.
We start with the basics. Unlike a traditional commercial mortgage which can be prepaid, a loan with defeasance clauses requires that the mortgage remains in place until maturity, but allows the real estate security to be replaced by securities (usually bonds of the Treasury). The defeasance transaction will be structured so that the treasury bills (1) have values at maturity equal to the remaining term of the loan and (2) a sufficient rate to produce enough cash to cover the monthly payments. debt service on the existing loan. With this structure in place, the existing borrower can have the lien released on the property. Simultaneously with the release of the lien on the property, an entity unrelated to the existing borrower will take over as the successor borrower of the loan with the treasury bills now serving as collateral.
Lenders typically require loan forgiveness when loans are bundled with many other loans and sold as securities, commonly known as commercial mortgage-backed securities. For example, Freddie Mac loans for multi-family projects are regularly bundled and sold as securities. Due to the complexity of this financial instrument, the lender must hold each borrower’s loan in place until maturity, rather than allowing a borrower to prepay and exit the loan.
The first step a borrower should take when considering loan forgiveness is to engage legal counsel to closely review existing loan documents for loan forgiveness provisions. Loan documents will outline defeasance requirements and associated fees. A cancellation fee is usually due before closing and will likely be non-refundable if the loan cancellation transaction is ultimately not completed.
The borrower will also normally pay all lender fees and expenses associated with the cancellation transaction, including lender’s attorneys’ fees. Interestingly, an unexpected benefit of recent interest rate increases is that the total cost of a loan forgiveness transaction for a borrower is likely to be lower than it was in past interest rate years. historically low. When interest rates rise, treasury bills used as alternative collateral for the mortgage loan become cheaper to purchase. Fully understanding all of the potential transaction costs of a loan forgiveness is a major concern, as these costs can affect the decision about when to refinance or sell a property.
Loan documents also normally limit when a loan cancellation transaction can take place. For example, there is usually a lock-up period after closing a loan so that the lender can have enough time to consolidate and sell the loan. In addition, the loan documents should contain very detailed notification requirements regarding the expected closing date of the loan cancellation transaction. A typical notice provision would require notice to be received 30 to 60 days prior to the loan cancellation closing date. Most loan documents also require the borrower to pay the cancellation fee when sending the cancellation notice.
Around the same time a borrower hires legal counsel to review their existing loan documents, a borrower should hire a loan forgiveness coordination specialist. Loan cancellation specialists can provide detailed projections of the costs of a cancellation transaction and will coordinate the workflow of the various parties. The use of a coordinator is recommended for any borrower, regardless of their familiarity with the process, as a loan cancellation is a highly specialized transaction.
A loan cancellation usually takes about 30 days to complete. To begin, the loan officer’s attorney will prepare a set of defeasance documents. Existing loan documents will dictate the substantive terms of those documents, including details of what securities the lender will accept, the appointment of a successor borrower, and the start of the defeasance process. Many of the legal documents required for a loan forgiveness are standard forms and lenders will be very reluctant to change them substantially, but they should still be carefully reviewed. The typical set of documents will include a pledge and guarantee agreement; an account agreement, an assignment, assumption and discharge agreement; various certificates; detailed escrow instructions; and a legal opinion from the borrower’s attorney. A borrower will also likely need to obtain a title insurance undertaking and prepare internal clearances for the transaction.
The main events of a loan cancellation transaction will include: (1) the borrower sending the lender notice of cancellation and a cancellation fee; (2) the lender acknowledges receipt of the notice and notifies the current borrower of the successor borrower; (3) the defeasance coordinator scheduling a kick-off call with all parties; (4) the borrower’s lawyer and the lender’s lawyer finalizing the legal documents; (5) the loan cancellation coordinator identifying treasury bills to be purchased from a broker; (6) funds being delivered for the purchase of treasury bills during a two to three day closing process; and (7) real estate being released from the loan and replaced by treasury bills.
A loan cancellation for a commercial real estate loan is a complicated and specialized process. However, if a borrower engages experienced professionals familiar with such transactions, navigating the transaction should be painless.
Sabina Shapiro and Adam Hattenburg are members of the Stoel Rives LLP real estate group.