Canada: Closed Commercial Mortgages: A Cautionary Tale

Last Updated: September 19 2019
Article by Houser Henry & Syron LLP

Houser Henry & Syron LLP frequently represents buyers and sellers in the purchase and sale of commercial properties. Every transaction is different, but with experience, buyers and sellers can identify problems early and prevent a deal from becoming unnecessarily stressful, complex and expensive.

What is a closed mortgage?

A closed mortgage tends to offer lower interest rates but less flexibility than an open mortgage. Generally, borrowers cannot pay back a closed mortgage loan until the mortgage matures. Though the lower interest rate may be appealing, the lack of flexibility (i.e. inability to renegotiate, repay or refinance for the duration of the mortgage) can be problematic when a borrower needs to "get out of" a closed mortgage. Many closed mortgages do allow a mortgage loan to be repaid before maturity upon payment of a prepayment penalty. Some mortgages however, are truly closed in that the mortgage terms prohibit prepayment before the maturity date.

A closed mortgage can restrict your ability to sell a property.

When selling a property with a mortgage, the seller must ask its mortgage company to relieve (discharge) it from its obligations under the mortgage. Unless the mortgage can be taken on (assumed) by the buyer and the buyer agrees to do so.

We recently assisted a client with the purchase of a commercial property. The vendor's mortgage was closed for prepayment, with a maturity date over a year after the scheduled closing date. The mortgage was closed for prepayment. The mortgagee took the position that the terms of the mortgage did not allow for the mortgage to be paid out and discharged, even if all principal and interest due up to the maturity date were paid in full.

The Vendor was unable to close on the scheduled closing date because the lender refused to provide a discharge statement. The lender suggested that the seller undertake an expensive and complicated "defeasance" transaction.

What is a defeasance?

When a borrower receives a loan from a lender, the lender needs security (collateral) to protect the money if the borrower cannot pay it back. Real property often serves as the collateral. When discharging the mortgage, the seller is asking the lender to stop using the real property as collateral. The lender will only agree to do that if they receive new collateral in place of the real property. The value of the new collateral must be sufficient to secure the loan balance and must accumulate the same interest cash flow. Usually, government securities or bonds work well, since they are low-risk investments with consistent interest accumulation. Replacing real property collateral with the new collateral is the defeasance transaction.

Closed commercial mortgages typically involve multiple parties. These lenders securitize (pool) several closed mortgages together and sell them to investors who benefit from the mortgage cash flow. This makes the defeasance process difficult because it requires several agreements between many different parties. It is common for a defeasance transaction to cost a borrower tens of thousands of dollars.

In our case, the vendor was eventually able to convince the lender to produce a discharge statement without having to go through a defeasance. The vendor had to pay interest to the end of the mortgage term, as well as the lender's legal fees associated with the discharge request. The vendor also had to pay our client's "out of pocket" expenses incurred because of the vendor's failure to close the deal as scheduled.

Even without a defeasance, these costs were substantial. In total, the vendor incurred approximately $170,000.00 in wasted interest and other costs.

Conclusion.

Before you enter into a purchase agreement, ensure you understand the terms of any mortgage that will need to be discharged. Failing to do so can result in unnecessary stress and expense.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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