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Defeasance - What, Why, How and When

What is Defeasance?

To start, here is the textbook definition of the word, "defeasance", according to Encyclopedia Brittanica 1911:

DEFEASANCE, or Defeazance (Fr. dFfaire, to undo), in law, an instrument which defeats the force or operation of some other deed or estate; as distinguished from condition, that which in the same deed is called a condition is a defeasance in another deed. A defeasance should recite the deed to be defeated and its date, and it must be made between the same parties as are interested in the deed to which it is collateral. It must be of a thing defeasible, and all the conditions must be strictly carried out before the defeasance can be consummated. Defeasance in a bill of sale is the putting an end to the security by realizing the goods for the benefit of the mortgagee. It is not strictly a defeasance, because the stipulation is in the same deed; it is really a condition in the nature of a defeasance.


[Note: If you want earlier history and use of a "defeasance", you can go back to England in the 1600's for an example of a defeasance for a deed.]


More current definitions of defeasance usually relate to real estate financial loans, such as the following examples:


1. Defeasance is a substitution of collateral. A portfolio of qualified U.S. government securities is structured such that it will produce sufficient cash flow to make all remaining payments due under the note as and when the same come due. The securities are pledged to the lender in exchange for the lender's release of the real estate from the lien of the mortgage. Conduit loan defeasances involve a number of parties, require a number of deliverables, and generally take about thirty days to complete.


2. Defeasance is an activity in which a borrower pledges something else as collateral to satisfy the terms of a loan in order to gain full title to the property without actually repaying the original loan. This practice is not necessarily widespread, but it can have useful applications [especially where there are significant prepayment penalties]. People usually work with a defeasance consultant when they wish to defease, and the process can become complicated, as lenders want to make sure that their borrowers have sufficient collateral to satisfy the terms of a loan [and avoid incurring additional tax liabilites] before they will be agreeable to defeasance.

This term is usually used in reference to real estate. In most real estate loans, the real estate itself serves as the collateral for the loan, and the lender holds a lien on the title until the loan has been repaid. When the borrower defeases, he or she finds something of equivalent value to use as collateral. If the lender accepts, the lien on the property is lifted and the borrower owns it in clear despite the fact that the loan has not been repaid.


Because of the cost involved to structure and implement a real estate defeasance, most involve commercial real estate loans:

Anatomy of a Commercial Defeasance - Introduction


Background. Many CMBS loans (i.e., commercial mortgage-backed securities, also called securitized “or conduit” loans [see also below]) prohibit prepayment. However, in lieu of prepaying the loan, after a lock-out period (usually three years), the borrower is permitted to pledge US Treasury obligations as substituted collateral and obtain the release of the liens encumbering the property. This process is known as defeasance. The reason that conduit loans must be "defeased" rather than prepaid is that most conduit loans are held in REMICs. The pass-through tax treatment of a REMIC generally requires that the REMIC invest only in "qualified mortgages." However, IRS regulations permit a defeasance to be done in conjunction with the sale or refinancing of the mortgaged property under Treas. Reg. 1.860G-2(a)(8). Although simple in concept, a defeasance can be difficult in practice.

Real Estate Mortgage Investment Conduit (REMIC) -
The most common type of mortgage-backed security. A REMIC entitles the owner to a claim on the principal and interest payments on the particular mortgages underpinning the security. REMICs pay an interest rate that is usually related to the interest rates the homeowners are paying on their mortgages. The equivalent of the coupon on a mortgage-backed security is a percentage of the interest and principal paid on the mortgages backing the security. REMICs can take different legal forms: trusts, partnerships, and assets without a legal status. They qualify for special tax treatment. REMICs were established by the Tax Reform Act of 1986.

(See also IRS Publication 938 - Real Estate Mortgage Investment Conduits (REMICs) Reporting Information)

Substitution of Collateral. From the lender’s perspective, the key to a defeasance transaction is to receive substituted collateral in a way that (1) will not cause any interruption in the payments under the note, and (2) will not cause the note to be paid in full for federal income tax purposes; and (3) to meet the IRS requirements to maintain REMIC status...

Sources: Anatomy of a Defeasance:  [PDF]  [PDF]


How Does It Affect My Commercial Real Estate Loan?

The rules that govern home loans are not the same as the rules that govern commercial real estate loans. One of the major differences is that there is usually no penalty for early repayment of a home loan, whereas investors in commercial real estate can face stiff penalties for early repayment. You might be thinking, “Why woudn’t my lender want to receive early payment on my commercial loan?” Early loan repayment is penalized when your loan has been securitized, meaning that your loan has been bundled with other loans and sold to bondholders as a debt security (in this case, a commercial mortgage-backed security [CMBS]). CMBS bondholders are expecting a certain rate of return on their security, and prepayment of your commercial loan will affect that rate of return.

What are 'Commercial Mortgage-Backed Securities (CMBS)'?

Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security that is secured by mortgages on commercial properties, instead of residential real estate. A CMBS can provide liquidity to real estate investors and commercial lenders. As with other types of MBS, the increased use of CMBS can be attributable to the rapid rise in real estate prices over the years.

Because CMBS are not standardized, there are a lot of details associated with them that makes their valuation difficult. However, when compared to a residential mortgage-backed security (RMBS) [see also above], a CMBS provides a lower degree of prepayment risk because commercial mortgages are most often set for a fixed term.

Read more: Commercial Mortgage-Backed Securities - CMBS


Although you cannot repay a commercial real estate loan as simply as you can a home loan, it is still possible to repay a commercial loan early, through a complex process called defeasance. Because bondholders are expecting a certain rate of return from your commercial loan, you are prohibited from engaging in defeasance during the first two years [or more] after your loan’s origination. However, after that two-year “lock-out period,” you can repay the loan, in a sense, by substituting your commercial loan and its stipulated interest rate with a portfolio of high-quality bonds (usually U.S. Treasury bonds). The yield on the bonds will replace the interest rate from your commercial loan, and the CMBS bondholders will continue to receive their expected rate of return.



What is the Process of a Defeasance?

Defeasance - Know your options:

"As interest rates remain at historically low levels, borrowers are looking for long-term fixed-rate refinance opportunities to take advantage of significant present value savings. However, for borrowers with fixed-rate conduit loans, such as commercial mortgage-backed securities (CMBS) and real estate mortgage investment conduits (REMIC), determining whether or not to “prepay” can be a nuanced process. This is where defeasance comes into play.

Defeasance is the process that releases a borrower from the obligations associated with its debt through the substitution of collateral. “Since 1998, nearly all fixed-rate conduit loans prohibit cash prepayment and instead require a substitution of the loan’s collateral,” said Josh Cohen, managing director of Commercial Defeasance, LLC.

CMBS certificate holders holding securities backed by the securitized loans want predictable and uninterrupted cash flow, according to a white paper by Kilpatrick Stockton LLP. As a result, virtually all CMBS loans prohibit a borrower’s prepayment of a loan prior to the expiration of a specified “lock-out” period. Without this prohibition on the borrower’s ability to prepay the loan, investors in the REMIC trust holding the CMBS loans would hold the interest rate risk associated with the loans held by the REMIC trust. "

The article continues with the required defeasance time and its roles, the process they will follow (estimated to take between 30 to 45 days, depending on the details of the transaction) and the costs, composed of cost of the collateral securities and third party transaction fees. (Third-party costs can range between $45,000 to $125,000 depending on the complexity and size of the defeasance; the cost to purchase the collateral securities is a function of the difference between the interest rate on the loan and the yield on the securities.).

What to Look For

If a loan requires defeasance, and it is beyond the lock-out period, the borrower can use an online defeasance calculator to obtain a defeasance cost estimate. However, a borrower interested in refinancing needs to consider how long the property will be held in order to calculate the time it would take to recover the defeasance premium through debt-service savings. If the debt-service savings will not be realized, the borrower’s specific objectives and the facility’s operational performance should be considered to measure the economic feasibility of the new loan.



Defeasance vs Assumptions: When to Asssume or Defease a CMBS Loan

CMBS loans are often sold to bond holders in the secondary market. As a result, they need to have predictable cash flow. In order to ensure that they do, loans are typically locked from any form of prepayment plan for most of the loan’s maturity life. Usually, this means about ten years. This prevents the loan from being paid off before it matures fully
But what happens when you want to sell your property? Those who decide to sell their property before their CMBS loan fully matures can do one of two things: assume the loan or defease it. Which one is the most appropriate choice?

The answer is: "it all depends."

Assumption vs. Defeasance

Commercial loan assumptions allow you to sell the property while the new borrower maintains the same terms and conditions already preexisting on the loan. This is a viable option if the loan has favorable terms and there is someone ready to take over the loan. Assumptions are the best course of action when the interest rate of the loan is greater than the interest rate of the bonds purchased.

When assumption is not a feasible option, defeasance is the best course of action. Here are some facts about defeasing your CMBS loan:
In a commercial loan defeasance, a loan cannot be paid off, so a collateral in the form of government securities – bonds, for example are used to substitute the property.

The bonds purchased must be enough to cover all payments made to the CMBS bond holders for the life of the loan.

Commercial loan defeasance is the best option when you’re selling or refinancing your property AND when the interest rate of the loan is less than the interest rate of the bonds.



Assumption Costs

The assumption costs include a loan assumption fee (typically 1% of the unpaid principal balance) and third party fees, as outlined below:

Assumption Costs




Why Defeasance Penalties are Worth It

Most often used in commercial real estate as the prepayment requirement on conduit/CMBS loans, defeasance is the process of releasing a commercial property from the lien of the mortgage and replacing it with a portfolio of U.S. government securities. Once a loan is defeased, the securities portfolio effectively replaces the borrower’s payment stream and makes the remaining mortgage payments on the loan, allowing the borrower to simultaneously either refinance or sell their property free and clear.

...many borrowers can actually save considerable amounts by defeasing today (See Table 1 below for sample analysis). For borrowers looking to take advantage of today’s lending market, defeasance presents the opportunity to move from 5.5-7.5% rates into 3.5-4.5% rates, while protecting themselves against probable interest rate increases over the next few years. In many cases, defeasing today means negating interest rate risk at a minimal cost.


... most borrowers view defeasance as a Treasury-rate game, believing that they should delay their defeasance as long as possible to lower their costs. However, as Table 1 demonstrates, the rewards associated with defeasing today can often outweigh the rewards of delay.



Why It May Be Worthwhile to Defease Now
(Rather Than Wait for Self-Storage Loan Maturity

For a self-storage borrower with a loan whose original principal balance of $10 million was originated in June 2005 at a 6 percent interest rate, the potential cost savings from defeasing now will be approximately $582,724, based on current interest-rate forecasts. As illustrated, the total cost to defease will be approximately $1 million, while total savings recognized by locking in a new 10-year loan at 4 percent interest rather than 5.5 percent interest will be approximately $1.6 million, resulting in a net profit. Should interest rates move above 5.5 percent, these costs will be even more substantial.

Self-Storage Defeasance*** 



When should you "pull the trigger" on defeasing a loan?

As stated previously, if you believe a loan is a good candidate for defeasance, and it is beyond the lock-out period, the borrower can use an online defeasance calculator to obtain a defeasance cost estimate.   This should help the borrowr determine if the next step of solitciting someone with defeasance expertise to handle the defeasance process is warranted, or at least better prepare them for the issues and potential costs they will need to address during their initial inquiries.

Here are some available online calculators [screen images - click on images or source links for the actual calculator web page] for you to use for extimating purposes and helping you to determine if defeasance might be a viable option for you and/or your business...

Defeasance Calculators

DefeanseWithEase Calculator


Loopnet Calculator


EquityDefeasance Calculator


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