Why are newer multi-family loans defeasing ahead of schedule?

14425526680_d34d3b66e6An interesting trend is developing in the multi-family CMBS space: Newer vintage loans are defeasing much earlier in their terms than older 2005- to 2007-vintage loans.

Why? Defeasance economics are turning in their favor. Let me explain.

Defeasance at a basic level is just matching yields — old rates to new rates. We can establish ballpark estimates of defeasance exit fees based on a few factors: original loan rate, replacement defeasance yield, and term to maturity. Over our 15 year history, we’ve seen defeasance costs average 10% to 15% of the loan balance.

Since the downturn, interest rates have been historically low (with the yield curve very steep), and defeasance volume has been fueled by term compression (less term = less interest = lower defeasance costs).  To keep costs down, very few loans with terms greater than two or three years would defease.

The recent surge in newer-issue K-Series loans provide us a glimpse into the defeasance future. The cost to defease is dipping below the 15% threshold quicker, with more term left to maturity.

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New vintage loans by nature have lower loan coupons, thus a smaller yield-gap to make up when it’s time to defease. Low loan rates combined with going further out on a steep yield curve create palatable defeasance economics, despite the increase in term.  For all newly originated CMBS loans, the likelihood of rising replacement treasury rates creates the strong potential for lower defeasance costs earlier into the loan term.

It is also easy to imagine scenarios where clients with more than five years to maturity can defease at par, with no penalty, or interest gap. Some borrowers may even defease at a discount to what they owe on the note balance if replacement yields surpass the loan rate.