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Valuing the Defeasance Option in Securitized Commercial Mortgages
Author(s) -
Dierker Martin,
Quan Daniel,
Torous Walter
Publication year - 2005
Publication title -
real estate economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.064
H-Index - 61
eISSN - 1540-6229
pISSN - 1080-8620
DOI - 10.1111/j.1540-6229.2005.00134.x
Subject(s) - equity (law) , commercial mortgage backed security , business , portfolio , treasury , loan to value ratio , market liquidity , finance , economics , financial system , monetary economics , mortgage insurance , history , archaeology , casualty insurance , political science , law , insurance policy
To protect the interests of investors, commercial mortgage loans pooled for the issuance of commercial mortgage‐backed securities (CMBS) have restrictive covenants that discourage the borrower from refinancing. Such restrictions limit the borrower's ability to access any accumulated equity. The predominant means of accessing this equity today is defeasance. By defeasing a loan, the borrower substitutes the commercial mortgage with U.S. Treasury or agency obligations whose payments match those of the defeased mortgage. Therefore, defeasance is an exchange option whereby the borrower gives up the portfolio of Treasury or agency securities and in return receives the market value of the commercial mortgage plus the liquidity benefits arising from accessing the accumulated equity in the underlying property. The value of the option to defease is shown to depend critically on the rate of return that can be earned on the released equity, prevailing interest rate conditions, as well as the option's contractual features.