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Welcome to the Self-Storage University Podcast, where you will learn the correct way to identify, evaluate, negotiate, perform due diligence on, renegotiate, finance, turn-around and operate self-storage facilities. And your host is a partner in one of the largest real estate portfolios in the U.S. with nearly $1 billion of holdings, Frank Rolfe.
Webster's Dictionary defines defeasance as the legal process of rendering a contract void upon the fulfillment of specific conditions. Kind of a nebulous concept, right? But if you've got a self-storage facility that is financed under a CMBS, which is also known as a conduit loan, then defeasance might really be a big deal to you. This is Frank Rolfe with the Self Storage University podcast. We're gonna talk about defeasance... What it is, how to work around it. And what defeasance really means is when you go to prepay a loan that's a commercial mortgage-backed security loan, known as CMBS, or another slang term is a conduit loan, they are going to charge you a big old penalty to prepay them. And this penalty is called defeasance. Now, why do they have to charge you a big penalty if you want to prepay a loan? Shouldn't they want their money back? Yes, but here's the issue. A conduit loan package is a grouping of properties, many different styles and types of properties. It can include everything from office and retail to mobile home parks and apartments. And these portfolios of properties... They're a portfolio to create diversity.
And they're packaged together and then sold to the American public. And these investors are buying a certain rate of return for a certain period of time. And if you prepay, then that monthly check they are to get is hampered because that money's not earning any interest. And they can't reloan the money because at this point it's not really a bank anymore. It's its own entity which has been sold to the public... This special grouping of properties at a specific interest rate with specific dates. So, since they can't reuse the money if you prepay them, all they can do is basically put it into a treasury, and that's it. And that interest rate is going to drop from whatever your interest rate was on your property. Let's say that was 7%... It's going to plummet all the way down to maybe 3% or 3.5%. And so they're going to charge you a massive penalty to hurt that bundle of properties to the tune of that big interest rate drop. And that's what defeasance actually is. Now, if you look up how big defeasance can be, it's going to blow you away. There's a website called defeasewithease.com where you can model your loan and your interest rate and the current interest rate and how many years are left on the loan, and it will tell you what the penalty will be.
But you better be sitting down when you do it, because the penalty is going to be substantial. That penalty might be a third of the entire principal amount of the loan. You will never see prepayment penalties that big ever on a traditional bank loan. And as interest rates go down, like they're starting to do now, defeasance penalties only get worse. So your timing couldn't be worse if you were trying to prepay a loan. If you wanted to prepay a loan that was put into service back in the year 2020, then your defeasance would be very little, because interest rates have gone up a lot. The interest rate on the treasury today might be the same as what your loan was. That would theoretically mean you might have no defeasance penalty. But with interest rates declining... And they have declined, and they will probably continue to decline... That only makes this issue worse. So it then begs the question: how do you work around defeasance penalties on CMBS conduit loans? Well, the first thing is to acknowledge that when you make the loan, that this does exist. If you want to take a property and rapidly flip it and sell it off, about the worst thing you could do would be to put it in a conduit CMBS loan. Because how's that gonna work? You might take all of your profit you thought you'd make in flipping the property and spend it on defeasance.
So here are some better solutions. If you have one of these loans and are trying to minimize the fees, here are some ideas for you. Number one, these loans allow assumption. So find a buyer who can assume the loan. That will eliminate defeasance altogether. Now, the buyer will have to pay some money out of pocket to get this assumption done. It's not free, but it's a whole lot less than what you would face with defeasance. But typically what's gonna happen, often with many buyers, is they'll say, "Now wait a minute though. If I assume your loan and I pay you more than what you paid for the property, then I'll have too much money in down payment on it." And that's true. If someone's trying to buy a property, let's say at 70% loan to value, and they're paying you more than what you paid, and you were at 70% loan to value, they may end up at 50% loan to value. And that lowers their leverage, makes their returns lower, so that may not work. Another option would be... Look at how long you still have on your loan. If your loan has well aged... If it was a 10-year loan and you're probably in year eight, your defeasance falls off a lot towards the end of the loan.
There's not as much time left on the loan, so the defeasance can be relatively much smaller. Also, I think many of the lenders really want you to start thinking about paying them off as you approach the final year. So the defeasance in the final year is very, very small. And that's simply because they don't want you to time out, to be unable to find another bank, which means your loan could technically go into what's called term default, because you were unable to find something new. So look at how much time you have left on the loan. It may be, "Well, wait a minute, my defeasance, even though it was a lot when I looked last time, now it's come down a whole lot." So that might also save you. Also, you might look into what the options are if you were to sell your entity with the loan already still in standing. I would get with your financial guys over your CMBS conduit lender and see how that would work... If instead of selling the asset, you sold the entity which owns the asset. That might give you some type of different path. Also, if you're the seller... Maybe the key item on all this to begin with is, once you do a deal with conduit, don't think about selling it so soon, because you know you have that defeasance risk. And additionally, if you are going to sell it fairly soon after making the loan, is the gain enough to offset the defeasance? If you're in a hot market, something that's rapidly ascending, maybe something like Charleston, South Carolina, it's theoretically possible you bought a self-storage facility three years ago, and the market is so hot and the offers are so high that even after deducting defeasance, it's still very attractive to you.
That may be another saving grace to the whole concept. But the bottom line is, if you're ever looking at getting a loan on storage that is CMBS, also known as conduit, you have to be aware of defeasance. I'm always shocked how many people are not paying attention to defeasance penalty, and then they reach out to me and say, "Wait, what is this defeasance penalty?" Well, read your loan documents. It's always been embedded in them. And again, if you want to see what the penalty is on your loan, if you already have a loan, go to defeasewithease.com, stick the numbers in, and see what the outcome might be. This is Frank Rolfe, the Self Storage University podcast. Hope you enjoyed this. Talk to you again soon.