Glossary
Defeasance
Defeasance is a way to release a property from a fixed rate commercial loan, most often a CMBS loan, by substituting government securities whose cash flows match the remaining loan payments. The loan stays outstanding and is paid from the securities, freeing the property to be sold or refinanced.
Formula
Example
A borrower defeases a $20,000,000 interest-only loan at 5% with four years remaining. The securities must produce $1,000,000 of interest each year and $20,000,000 at maturity. If Treasury yields are 4%, the portfolio costs about $3,629,895 for the interest stream plus $17,096,081 for the principal, totaling $20,725,976. The defeasance premium is about $725,976 above the balance, before legal, accounting and successor borrower fees.
How it is used in underwriting
Defeasance exists because CMBS loans are pooled into securities whose investors expect stable cash flows, so the loan cannot simply be prepaid. Instead, the borrower funds a securities portfolio, a successor borrower entity assumes the loan, and the property's lien is released. Underwriters and investors evaluating a sale or refinance of a CMBS-financed property must estimate defeasance costs, which depend on the difference between the loan rate and current Treasury yields and on the remaining term. Specialist consultants usually manage the process, which can take several weeks.
Like yield maintenance, defeasance is costly when rates have fallen and cheaper when rates have risen. If Treasury yields exceed the note rate, the replacement portfolio can cost less than the outstanding balance, though fees still apply and some structures do not pass the savings to the borrower. Many CMBS loans have a lockout period after securitization during which defeasance is not allowed and an open period near maturity when the loan can be prepaid at par. Buyers sometimes assume the existing loan instead of paying to defease it, which requires servicer approval and an assumption fee.
Frequently asked questions
Why do CMBS loans require defeasance?
CMBS loans are pooled and sold to bondholders who expect predictable payments. Defeasance keeps the loan and its cash flows intact by replacing the property collateral with Treasury securities, so investors keep receiving scheduled payments while the borrower is released from the property. Tax rules governing securitization vehicles also make straightforward prepayment difficult.
How much does defeasance cost?
The cost equals the price of the securities portfolio needed to replicate the remaining loan payments, minus the loan balance, plus fees for consultants, lawyers, accountants and the successor borrower. It rises when Treasury yields are below the loan rate and when many years remain. Borrowers should get an estimate early.
Is defeasance the same as prepayment?
Not technically. In a prepayment, the loan is repaid and ends. In defeasance, the loan remains outstanding until maturity, but it is secured and paid by government securities rather than the property. The economic effect for the borrower is similar to prepayment with a market-based premium.
Related terms
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