Erika Morphy is co-editor of Debt and Equity Journal, from which this article is excerpted.

Kennett Square, PA—Chatham Financial, a specialty finance firm that provides defeasance services, has structured a $150-million defeasance transaction for the L'Enfant Plaza in Washington, DC. The deal is not noteworthy for its size, although it is a large transaction, or for the building itself, one landmark out of many in the heart of the city. Rather, it is significant because the borrower, the JBG Cos., recovered more than $590,000 of residual value at the maturity of the defeasance.

Since early 2005, Chatham has been sharing 75% of the residual value of interest earned on securities that have been purchased to defease CMBS transactions. This amount could be miniscule, says Jodi Eppler, director of Chatham's defeasance service, or it could be a significant number--depending on the size and term of the loan.

"The securities will typically kick off payments on the 15th or 31st of the month," she explains. "If a loan doesn't have a payment date until the 11th, for example, that payment sits in the successor borrower account earning interest until it is time to make the payment." Balloon payments could be earning interest in the account for as long as three months.

"No one has access to the float until the loan is paid off," she says. "But once it is paid off and the loan is retired, the money is available for a sharing arrangement." Chatham Financial feels justified keeping 25% because of the costs involved.

Before 2005, Eppler says, it was industry standard for the defeasance provider to keep all this money. Slowly, though, this practice is changing and more defeasance consultants are sharing the residual value. One company, Waterstone Capital Advisors of Charlotte, NC, advertises its willingness to share the residual value with clients on its website. Another provider, Eppler adds, will do so if asked.

John Hosmer, president and CEO of Commercial Defeasance LLC in Charlotte, NC, the largest provider of defeasance services in the industry, says his company would consider such a transaction, although it has yet to be asked. Hosmer, though, is uncertain whether the benefits to the borrower outweigh the potential drawbacks.

"We have some misgivings," he says. For starters, servicers and rating agencies have not fully vetted this process. More significantly, it could have adverse tax ramifications for the borrower, he says.

The defeasance provider is entering into a de facto partnership with the borrower in which the borrower has claim to a continuing benefit and return on the proceeds from the securities. Instead of transferring the securities to the successor borrower, the original borrower would have to keep the securities on its books and file tax returns that reflect this sharing arrangement. In the event that the borrower declares bankruptcy, the court is likely to want to bring those securities into the bankruptcy estate, thus negating the benefits of setting up a special purpose vehicle for the transaction in the first place. "This is an issue about which we would want the borrower to be fully apprised," Hosmer says.

Instant Insights /

Defeasance Reaps Residual Value

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