Releasing property collateral from a loan by substituting a portfolio of government securities engineered to make the remaining loan payments.
The longer version
Defeasance is the way most securitized commercial mortgages are paid off before maturity. Rather than repaying the loan, the borrower replaces the real estate collateral with a portfolio of government securities whose payments match the loan's remaining scheduled payments. The loan stays outstanding and the property is released.
The mechanics follow from how a CMBS loan is held. The investors in the trust are owed a predictable stream of payments, so early repayment would break the structure. Defeasance preserves the stream: a successor borrower entity assumes the loan, holds the securities, and makes the payments through maturity, while the original borrower walks away with an unencumbered property.
The cost is the price of the replacement securities plus the fees of the defeasance consultant, the securities intermediary, counsel and the servicer. It moves with interest rates. When rates have fallen since origination, the securities cost more than the loan balance and defeasance is expensive. When rates have risen, it can cost less than the balance.
Defeasance is distinct from yield maintenance, which is a prepayment premium paid in cash, and from the defeasance clause found in many mortgages, which simply provides that the lien is released when the debt is paid.
Common questions
- What is defeasance in commercial real estate?
- A way to release a property from a loan before maturity by substituting government securities whose payments replicate the remaining loan payments. The loan stays outstanding, held by a successor entity, and the borrower's property is freed of the lien. It is standard in CMBS.
- What is a defeasance clause?
- A provision in many mortgages stating that the lender's lien is released once the debt is fully repaid. It is a different and much older use of the word than CMBS defeasance, which is a prepayment mechanism.
- How much does defeasance cost?
- The cost of the replacement securities plus consultant, legal, intermediary and servicer fees. The securities cost depends on interest rates: higher than the loan balance when rates have fallen since origination, potentially lower when rates have risen.
- What is the difference between defeasance and yield maintenance?
- Yield maintenance is a cash prepayment premium that compensates the lender for lost interest, after which the loan is gone. Defeasance replaces the collateral with securities and keeps the loan alive. CMBS loans typically require defeasance; balance sheet lenders more often use yield maintenance.