Exploring the Relationship Between Interest Rates and Defeasance Penalties

Jonathan Hipp

It isn’t often that we hear discussions of rising interest rates couched in good news. But when we fold in the topic of defeasance obligations, we break that trend. To put it succinctly, the possibility of rising rates has the potential of minimizing or even wiping out the costs associated with defeasance. 

First, let’s get some definitions out of the way. For those who may not have run into defeasance before, it essentially represents the funds set aside to cover a borrower’s loan costs. Dealing with those costs is arguably among the major hurdles to getting assets to market, owing to the hesitation of the buyer or seller to pay a penalty that didn’t make economic sense. In fact, in our shop, we are currently working on a number of net lease deals where the potential of rising interest rates could eliminate defeasance payments upward of $15 million. 

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

But those benefits are counterbalanced by what is itself a complex structure, demanding the input of accountants and lawyers and the need for the borrower to have enough available capital to cover the cost of the collateral being freed. For this reason, we strongly recommend not treading into the waters of defeasance without consulting with an experienced advisor.

When Interest Rates Rise 

Simply speaking, when interest rates fall, defeasance costs rise, and when rates rise, borrowers reap the benefit of lower defeasance penalties. It makes sense then that many borrowers use that very situation to market assets they previously held back.

This last point is key since property owners will be more greatly incentivized to bring more assets to market rather than enduring a costly refi. Thus, interest rate conditions create a market-wide win/win.

This scenario is being borne out by the current inflationary period, when the average 30-year fixed interest rates hover around 3.7 percent, which one of our sources dubs “the highest average since May 2019.” All signs point to a continuation of that trend for the foreseeable future. This is especially true in periods of international distress, such as we are now experiencing with the Ukrainian crisis. 

Speaking for ourselves, another 33 basis-point rise will virtually wipe out the defeasance penalty on the above-mentioned transactions. Speaking more broadly, 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 U.S. Net Lease Group at Avison Young.