During the last cycle,

October 2016 Breaking Down Defeasance CMBS borrowers should understand the prepayment process. By Thomas Welch and John Poole During the last cycle, commercial mortgage backed securities lending gained in popularity, culminating in a frantic pace of origination between 2005 and 2008. During that period, many borrowers went through loan defeasance, but for a fairly long stretch of time following the CMBS market implosion, the economics of defeasance rarely made sense. However, with rates still near historic lows and commercial real estate prices favorable to sellers, many more loans will enter into defeasance over the next several years. This article discusses what borrowers should know if they are considering defeasance, and why they should ask for defeasance prepayment provisions in a new loan. What Is Defeasance? Defeasance is the standard CMBS industry alternative to traditional prepayment penalties such as the yield maintenance penalty common to life insurance company loans and fixed percentage penalties common to local bank loans. Rather than being a true prepayment, defeasance is the substitution of securities collateral for real estate collateral. This allows a release of the property lien, freeing the asset for refinancing or sale. A borrower s property is released when a portfolio of U.S. government securities is structured to replace the cash flow covering the debt service. A special purpose entity, known as the successor borrower, assumes the role of the borrower and makes payments on the loan using the portfolio of securities. The complexity and upfront costs of loan defeasance can be intimidating, and the intricate process has often led to an uneven playing field. Leveling the Playing Field In This Issue 1, 3-5 Featured Article 2-7 Featured Listings 7 Submit Your Article 8 Recent Deals Bill Gladstone, CCIM, SIOR (717) 761-5070 ext. 120 wgladstone@naicir.com www.billgladstone.com www.naicir.com Given a choice, most borrowers would prefer yield maintenance or fixed percentage prepayment penalties to defeasance. However, variations to defeasance are uncommon and require spread premiums if elected in a CMBS financing. Yield maintenance, though it requires careful math to estimate accurately, is simple enough to calculate, and fixed percentage penalties are even simpler. Due to the opaque nature of defeasance, defining it up front and calculating when Bill Gladstone Group of NAI CIR Turning keys in commercial real estate for over 29 years. (Continued on page 3) A publication of the Bill Gladstone Group of NAI CIR

New Listings 3,930 SF NEW Commercial Lease - 4301 Jonestown Road, Harrisburg Restaurant space available across from Red Lobster and the Colonial Park Mall Nice corner location at very busy, heavily traveled singnalized intersection along Route 22 Average daily traffic is over 40,000 4,800 SF NEW Industrial Lease - 26 Northeast Drive, Hershey Large, open flex space conveniently located near many Hershey attractions and major thoroughfares Tall ceilings and open floorplan allow for many types of uses Over 100 parking spaces total; 35+/- in common with all tenants in this building Industrial Listings 3,224 SF NEW Office Sale - 4405 N. Front Street, Harrisburg Nice office building along the Susquehanna River with beautiful views 20+ Parking spaces available Attractive curb appeal Great access to I-81 and Routes 11/15 and various amenities such as restaurants and hotels close-by Connect With @GladstoneGroup Today! www.billgladstone.com 1,000-4,000 SF Lease - 1779 W. Trindle Road, Bldg. 600, Carlisle Shop space along busy Trindle Road Easy access to I-81 and the rapidly growing Carlisle area Located right in the heart of new retail and industrial parks Adjacent to the Target anchored Carlisle Crossing Shopping Center 70,710 SF Lease - 151 Allendale Road, Mechanicsburg Functional warehouse space with 1,000 SF being office Easily accessible from US Route 15, PA Route 581 and I-81 Including six docks: 8' x 8' 2 Information concerning these offerings comes from sources deemed reliable, but no warranty is made as to the accuracy thereof, and they are submitted subject to errors, omissions, change of price or other conditions, prior sale or lease, or withdrawal without notice. All sizes approximate. NAI CIR, 1015 Mumma Road, Wormleysburg, PA 17043 PA License #RB024320A 717 761 5070 l www.naicir.com

(Featured article...continued from page 1) implementing it requires borrowers to seek good advice and demand transparency. Using a qualified intermediary can help. For instance, Colliers Boston partners with select defeasance providers who review existing loan documents, issue quotes specifically tailored to the loan provisions, and periodically update the costs until the time for defeasance is right. Using an intermediary has several advantages over relying on an online defeasance calculator. Most notably, it provides reliability through a review of replacement collateral requirements and the defeasance duration period. For example, certain CMBS loans provide a choice between defeasance and yield maintenance, or allow borrowers to substitute replacement securities that offer a higher yield than Treasury instruments. In short, borrowers have the opportunity to confirm what their true prepayment situation is. When it comes time to initiate defeasance, transparency becomes even more important. Are the replacement securities optimized for the borrower? Are the transaction costs fair? Is the borrower the beneficiary of the value of the successor borrower? Borrowers should think about this. Most loans have a 30- to 180- day open prepayment window, but most older loan documents require the borrower to buy replacement securities through loan maturity. If the successor borrower later repays the loan at the beginning of the open prepayment window, it will reap a windfall. Will the borrower participate in that windfall when it happens or be offered a present value share of that value at the time of defeasance? Simply put, understand that two variables the reduction of the remaining loan term and increased replacement securities yields decrease the cost of defeasance. One of the fundamental benefits of defeasance is the flexibility to refinance the property at current low rates. Like yield maintenance, the present value of remaining interest payments generally represents the largest component of defeasance cost. "One of the fundamental benefits of defeasance is the flexibility to refinance the property at current low rates." The most obvious risks in deferring a refinance until the open period are the possibility of a higher interest rate and the maturity risk from refinancing in less liquid future capital markets. Therefore, if a qualified intermediary has modeled the loan defeasance, the borrower can monitor rates, capital market conditions, and defeasance costs in real time to better react at an optimal point in time. For many borrowers, that optimal point in time comes 12 to 18 months prior to loan maturity. Still others employ alternative strategies, such as a forward loan rate lock to reduce or eliminate prepayment costs, or a sale with assumption of the debt as a way to avoid defeasance. Also, the prepaid interest component of defeasance may be tax deductible, something borrowers should discuss with their tax professional as a part of an overall portfolio strategy. Ultimately, deferring a refinance in a rising rate environment means borrowers this year could lose out by waiting until 2017 or 2018 to refinance. (Continued on page 4) Industrial Listing 1,484-11,318 SF Lease - 3525 N. 6th Street, Harrisburg Large economical warehouse space recently underwent renovations Various warehouse sizes and features can be accommodated Located close to downtown and just off Front Street at I-81 Investment Listing Portfolio of 4 properties; 3 existing buildings and 3 acre vacant parcel Sale - 5620-5630 Derry Street, 5650-5670 Lancaster Street, Harrisburg Now offering a 9.03% CAP rate Stable income from strong credit tenant and tremendous upside from the vacant 3 acres that can accept additional office/ commercial buildings High visibility and excellent parking Commercial Listing 8,071 SF Sale - 8926 Jonestown Road, Harrisburg Former VFW available for sale on 4+ acres of land Building has large rooms and a fully equipped commercial kitchen Good parking ratio in paved lot 3

(Featured (Featured article...continued article...continued from from page page 1) 3) Office Listings Reducing Defeasance Costs When financing a property with CMBS debt, borrowers should attempt to negotiate several favorable defeasance provisions. For example, they should define defeasance collateral to include not only U.S. Treasuries but also other agency securities that may have a higher yield. They should seek the right to designate the successor borrower. If possible, they should secure the right to loan defeasance only through the start of an open period as opposed to through maturity. Also they should ask for the rights to deliver securities instead of cash to the lender for their purchase, cap servicer defeasance fees, and choose between defeasance and yield maintenance. 1,946-4,656 SF Lease - 3525 N. 6th Street, Harrisburg Flexible office space available for lease Newly renovate suites available on the second floor Building is under new ownership and undergoing major renovations Good on-site parking Defeasance can be a powerful tool in today s low interest rate market. While the defeasance cost will decrease over time to zero, rising interest rates will make new debt more expensive and reduce cash flow after debt service. Using an experienced mortgage broker who works with a qualified defeasance intermediary can help to take advantage of the available refinance opportunities. If the cost of defeasance today makes refinancing unattractive, the broker and defeasance intermediary can provide, at the least, a quarterly real-time, hard defeasance quote and feasibility analysis based on current financing market conditions. Lease - 4400 Deer Path Road, Harrisburg Class A, suburban high profile two-story office building Located at signal controlled intersection Close proximity to I-81 and Downtown Harrisburg 1,768 SF Does Defeasance Make Sense? The decision to use defeasance in order to refinance depends on a number of factors, but the financial analysis aspect is relatively straightforward. For example, in 2007, Colliers originated a $12 million loan with a term of 10 years, an amortization of 30 years, and an interest rate of 5.75 percent. The annual debt service was approximately $840,000, with a remaining loan balance of approximately $10,350,000 at the time of refinancing, 8.5 years into the loan term. Defeasance and refinancing transactions costs totaled slightly more than $950,000. Colliers obtained competitive bids for a new loan sized to 100 percent of refinancing costs, and recommended a nonrecourse option with a 10-year fixed rate of 4.50 percent, amortized over 30 years and new annual debt service of approximately $690,000. This resulted in an increase in pre-tax net cash flow of $150,000 to (Continued on page 5) 3,723 SF Sale - 5006 E. Trindle Road, Unit 101, Mechanicsburg First floor brick condominium available for sale The space features a large, open floorplan which allows for a multiple number of uses Ideal location along rapidly growing Trindle Road and allows for quick access to Routes 581 and 15 Price Reduced 4 Information concerning these offerings comes from sources deemed reliable, but no warranty is made as to the accuracy thereof, and they are submitted subject to errors, omissions, change of price or other conditions, prior sale or lease, or withdrawal without notice. All sizes approximate. NAI CIR, 1015 Mumma Road, Wormleysburg, PA 17043 PA License #RB024320A 717 761 5070 l www.naicir.com

(Featured article...continued from page 4) the borrower. Additionally, the client s tax professional advised that a significant portion of the defeasance costs and transactions fees would provide valuable tax benefits to the client. Between the reduction in debt service and the value of tax deductions, the time to recoup cost was relatively short. Moreover, given that the borrower could refinance to a lower rate with no cash out of pocket and eliminate both refinance risk in 18 months and interest rate risk for 10 years, defeasance and refinancing made sense. (See Defeasance Example chart.) Sometimes defeasance is not feasible. A loan may be locked out from prepayment, deals with longer remaining terms may be simply too expensive to refinance, or the property cash flow and valuation may not be able to support a loan large enough to wrap in defeasance and transaction costs. On the other hand, borrowers often choose to defer defeasance for loans with less than 12 months remaining until the open period or maturity. In this scenario, Colliers has used forward rate commitments with insurance companies and banks to rate lock for up to 12 months in advance of refinancing to significantly reduce defeasance costs or eliminate them altogether. The first 60 to 90 days of a forward-rate lock are typically premium-free, after which a premium of 2 to 6 basis points per month is added to the rate. In summary, borrowers who have loans with defeasance provisions should have a qualified party model defeasance based on the specific loan document provisions now. Even if it is not feasible to use loan defeasance now, borrowers should request periodic real-time updates of the defeasance cost. If borrowers are 12 to 24 months from maturity or open prepayment period, they are likely close to the sweet spot for refinancing to a lower rate. Such preparation now will better position borrowers to move quickly when they determine the time is right. Thomas Welch is senior vice president and John Poole is an associate of the capital markets team at Colliers International in Boston. Contact them at Thomas.Welch@colliers.com and John.Poole@colliers.com. Defeasance Example ORIGINAL LOAN Original loan amount (2007) $12,000,000 Interest rate 5.75% Term (years) 10 Amortization (years) 30 Amortizing annual debt service $840,000 Remaining loan balance (January 1, 2016) $10,350,000 DEFEASANCE COSTS Remaining loan balance after 8.5 years $10,350,000 Prepaid interest $760,000 Transactions fees $50,000 Total defeasance cost $810,000 REFINANCE New loan amount $11,310,000 Interest rate 4.50% Term (years) 10 Amortization (years) 30 Amortizing annual debt service $687,673 TIME TO RECOUP Original debt service $840,000 Refinance debt service $687,673 Amortizing annual debt service savings $152,327 Total defeasance cost $810,000 Time to recoup (years) 5.3 Term remaining after recouping costs (years) 4.7 Money saved over life of the loan $713,267 Office Listings Reprinted with permission from Commercial Investment Real Estate, The Magazine of CCIM Institute July/August 2016 Vol. XXXVI No. 4 Lease - 1801 Oberlin Road, Suite 300, Middletown Charming three-story stone structure with professional office tenants Convenient access to both Harrisburg and Lancaster Easy access to Harrisburg International Airport 783 SF 566-3,113 SF Lease - 415 Market Street, Harrisburg Attractive office spaces at the Harrisburg Transportation Center In walking distance to all the downtown restaurants, amenities, and Riverfront Park Located in Technology Corridor Enterprise Zone 50% off base rent for first lease year 5

Office Listings 4,542 SF Sublease - 208 N. Third Street, Suite 400, Harrisburg New sublease opportunity in completely renovated and updated suite on the 4th floor Historic building faces the Capitol Complex with great window lines Downtown amenities are just a few steps from the doors and parking is a block in every direction 3,600 SF Lease - 4231 Trindle Road, Camp Hill Two-story property with tremendous exposure at a signalized intersection Former bank with an open first floor and offices with windows on the second floor The layout can be altered to allow for a variety of uses 4,744 SF Sale - 3029 N. Front Street, Harrisburg - Price Reduced! Three-story building has lovely character and amazing river views Property has been well-maintained and was fully renovated in 2008 Great attention to detail was made to modernize the property while keeping the early 1900's feel 150-700 SF Lease - 800 N. Third Street, Harrisburg - Price Reduced! Prominent downtown office building across from the State Museum One block from the Capitol Complex; perfect location for attorneys and associations On-site parking available and many other amenities are available to tenants 6,684-16,434 SF Sale - 1029 Mumma Road, Lemoyne - Price Reduced! Attractive office building available in well-established business park along the West Shore business corridor Access to all major business hubs on both East and West Shores Well-maintained, features modern upgrades, and on-site parking 9,750+/- SF is currently leased until October 2017 6 3,103 SF Lease - 156 Cumberland Parkway, Mechanicsburg Locate your business in this first class, high profile building The location offers easy access to Route 15 and the PA Turnpike (I-76), plus great local amenities It is hereby disclosed that a partner in the ownership of this property is a licensed real estate salesperson in the Commonwealth of Pennsylvania

Submit us Your Article Featured Land Share your expertise and be published in Bill Gladstone Group of NAI CIR's magazine or newsletter publication. Give your company exposure to over 4,000+ business professionals. Submit article topics to: Chuck Bender, cbender@naicir.com (717) 761-5070, ext. 152 Sale - 300 S. Sporting Hill Road, Mechanicsburg Over 1 acre of level land located along Sporting Hill road Great for medical, professional or business office users Adjacent to the Hampden Township office Average daily traffic along S. Sporting Hill Road is 17,023 1.19 Acres Land Listings Location Acres Zoning Type Pending - 5148 E. Trindle Road, Mechanicsburg, Cumberland County (Route 641) 1.0 Commercial Limited Sale Pending (1 Parcel) - 370 W. Main Street, Leola, Lancaster County 1.3-2.8 General Commercial Sale/Lease Allentown Boulevard and N. Hershey Road, Harrisburg, Dauphin County 1.35 (1 lot) Commercial Highway/Office Sale Pending - 7940 Grayson Road, Harrisburg (Rear Lot) 1.6 Limited Manufacturing District (ML) Sale 300 S. Sporting Hill Road, Mechanicsburg, Cumberland County 1.19 Apartment Office Limited (AOL) Sale I-81 and W. Trindle Road, Carlisle, Cumberland County 2.18 (2 parcels) Commercial Highway Sale Price Reduced - East Cumberland Street (Route 422), Lebanon, Lebanon County 2.2 Commercial Sale 7700 Derry Street, Harrisburg, Dauphin County 2.3 (lot 8) Commercial District General Sale/Lease Route 114 & Gettysburg Pike (NEC), Mechanicsburg, Cumberland County 2.97 Highway Commercial District Sale Pending - 6325 Chelton Avenue, Harrisburg, Dauphin County 3.75 Zoned for business use Sale/Lease 700 S. Baltimore Street, Dillsburg, York County 5.23-57.5 Agricultural - Conservation (AC) Sale Route 114 & Gettysburg Pike (NWC), Mechanicsburg, Cumberland County 7.12 Highway Commercial District Sale Lancer Street Extended, Harrisburg, Dauphin County 7.52 Medium Density Residential (R-2) Sale Route 441 and Orchard Drive, Harrisburg, Dauphin County 8.34 Single Family Residential District Sale 730 Limekiln Road, New Cumberland, York County 8.64 Commercial Business Sale 2600 Delta Road, Brogue, York County 2.5 General Commercial Sale/Lease Eisenhower Blvd & Highspire Road, Harrisburg, Dauphin County 10 Commercial District General Sale 7700 Derry Street, Harrisburg, Dauphin County 10.19 (lots 4-8) Commercial District General Sale Route 75 & William Penn Highway, Mifflintown, Juniata County 11 Industrial Commercial Sale/Lease Carlisle Pike (Route 11) Waterford Square, Mechanicsburg, Cumberland County 16.16 (13 lots) Community Commercial (C2) Sale Price Reduced - Allentown Boulevard, Harrisburg, Dauphin County 17+ Commercial Highway (CH) Sale 3050 Heidlersburg Road, York Springs, York County 18.16 Highway Commercial Sale/Lease www.billgladstone.com 717 761 5070 l www.naicir.com Information concerning these offerings comes from sources deemed reliable, but no warranty is made as to the accuracy thereof, and they are submitted subject to errors, omissions, change of price or other conditions, prior sale or lease, or withdrawal without notice. All sizes approximate. NAI CIR, 1015 Mumma Road, Wormleysburg, PA 17043 PA License #RB024320A 7

PRESORTED STANDARD U.S. POSTAGE PAID Harrisburg, PA Permit No. 783 BILL GLADSTONE, CCIM, SIOR NAI CIR PO Box 8910 Camp Hill, PA 17001-8910 717 761 5070 www.naicir.com www.billgladstone.com Commercial Agent/Agency Check Out Our Recent Deals Visit www.billgladstone.com to view listings not included in this issue. SOLD - 6 Pine Hill Drive, Carlisle, PA 6 Pine Hill Drive, LLC purchased a 83,544 SF warehouse located at 6 Pine Hill Drive in Carlisle, PA. Jeffrey Williams of Cushman & Wakefield represented the Buyer. The Bill Gladstone Group of NAI CIR represented the Seller. SOLD - 2969 N. 7th Street, Harrisburg, PA BW Wilson purchased an 85,000 +/- SF warehouse located at 2969 N. 7th Street in the City of Harrisburg. The Bill Gladstone Group of NAI CIR represented the Seller and Roy Brenner of Landmark Commercial Realty represented the Buyer. LEASED - 3525 N. 6th Street, Harrisburg, PA I-Deal Cars LLC, an automobile repair workshop, leased 3,300 SF of warehouse space at 3525 N. 6th Street in Harrisburg from Shree Group LLC. The Bill Gladstone Group of NAI CIR handled the transaction. Space still remaining, call for details!