Exploring the relationship between interest rates and defeasance penalties

jonathan hipp

It’s not often that we hear talk of rising interest rates accompanied by good news. But when we come to the subject of defeasance bonds, we break this trend. To put it succinctly, the possibility of rising rates has the potential to minimize or even eliminate the costs associated with defeasance.

First, let’s eliminate some definitions. For those who may not have run into a forfeiture before, this essentially represents funds set aside to cover a borrower’s loan costs. Dealing with these costs is arguably one of the main obstacles to bringing assets to market, due to the reluctance of the buyer or seller to pay a penalty that did not make economic sense. In fact, in our shop, we are currently working on a number of net leases where the potential for rising interest rates could eliminate the $15 million upside defeasance payments.

To state the obvious, there are, of course, advantages to defeasance. These include a simpler accounting framework (a real boon in an environment already made more complicated by recent accounting changes imposed by the Financial Accounting Standards Board) and a reduced risk of prepayment penalties.

But these advantages are offset by what is in itself a complex structure, requiring the input of accountants and lawyers and the need for the borrower to have sufficient capital available to cover the cost of the collateral released. For this reason, we strongly recommend that you do not tread the waters of defeasance without consulting an experienced advisor.

When Interest Rates Rise

Simply put, when interest rates go down, cancellation costs go up, and when rates go up, borrowers enjoy lower cancellation penalties. It therefore makes sense that many borrowers are taking advantage of this situation to market assets they previously held back.

This last point is essential because owners will have more incentive to put more assets on the market rather than suffer a costly refi. Thus, interest rate conditions create a market-wide win/win.

This scenario is confirmed by the current inflationary period, when average 30-year fixed interest rates are hovering around 3.7%, which one of our sources calls “the highest average since May 2019”. All signs point to a continuation of this trend for the foreseeable future. This is especially true in times of international distress, such as the one we are currently experiencing with the Ukraine crisis.

Speaking for ourselves, another 33 basis point hike will virtually wipe out the defeasance penalty on the aforementioned trades. More generally, it is clear that unlocking more potential assets for sale will be good for all investors. Isn’t it a nice change of pace to have a reason to celebrate rising interest rates?

Jonathan Hipp is head of the US Net Lease group at Avison Young.

Leslie M. Gill