Defeasance

What Is Defeasance?

Defeasance is a method of releasing a commercial property from its mortgage by replacing the property as collateral with a portfolio of U.S. government securities. The securities are structured to generate cash flows that exactly match the loan's remaining payment schedule, month for month, through maturity. Once the substitution is complete, the borrower gets clear title to the property while the lender (or bondholders, in a CMBS structure) keeps receiving payments as though the loan were still in place.

Unlike a simple payoff, the loan itself does not terminate. The debt stays on the books, backed by Treasuries instead of real estate. This distinction matters for CMBS because the bonds backed by that loan continue performing exactly as expected, which is why CMBS lenders strongly prefer defeasance over other prepayment methods.

How Defeasance Works

The process has several moving parts, but the core mechanics are straightforward:

1. The borrower hires a defeasance consultant (firms like Chatham Financial, AST Defeasance, or Derivative Logic specialize in this).
2. The consultant calculates which combination of U.S. Treasury securities will replicate the loan's remaining payment schedule exactly.
3. The borrower purchases those securities. This is typically the largest cost component.
4. A successor borrower (usually a special purpose entity created for this purpose) assumes the loan, with the securities as the sole collateral.
5. The original property is released from the mortgage lien.
6. The securities pay out to the servicer each month, covering principal and interest through the original maturity date.

The borrower walks away with a free-and-clear property. The lender's cash flow stream is unchanged. The CMBS bondholders never know the difference.

What Defeasance Costs

Defeasance costs have several components:

The securities cost is what makes defeasance expensive or cheap, and it depends entirely on the relationship between the loan's interest rate and current Treasury yields.

When Treasury yields are lower than the loan rate, you need more money to buy securities that generate the same payment stream. The securities produce lower yields, so you need a larger principal amount to match the loan payments. This is the scenario that makes defeasance costly.

When Treasury yields are higher than the loan rate, the opposite happens. The securities produce higher yields, so you need less principal to replicate the payments. In some high-rate environments, defeasance can actually cost less than the remaining loan balance.

Defeasance vs. Yield Maintenance

Both mechanisms exist because commercial lenders, especially CMBS, do not allow simple prepayment. The loan documents specify which method applies. Here is how they compare:

In a low-rate environment (Treasury yields below loan rate), yield maintenance is almost always cheaper. In a high-rate environment (Treasury yields above loan rate), defeasance can be cheaper because the securities cost less. The loan documents control which option is available, so this is rarely a choice the borrower gets to make after the fact.

When Defeasance Is Required

Most CMBS loans originated after the mid-2000s require defeasance as the sole prepayment mechanism during the lockout period. The lockout period is typically the first two to three years of the loan term, during which no prepayment is allowed at all. After lockout, defeasance becomes available and remains the only option until the open prepayment window, which is usually the last three to six months before maturity.

The typical CMBS prepayment structure looks like this:

Some CMBS loans allow yield maintenance instead of or in addition to defeasance. Always check the loan documents carefully. The promissory note and the pooling and servicing agreement (PSA) govern which mechanisms are available.

The Defeasance Process Step by Step

Step 1: Review loan documents. Confirm that defeasance is permitted, check the lockout period has passed, and identify any notice requirements (many servicers require 30 days written notice).

Step 2: Hire a defeasance consultant. The consultant handles securities structuring, coordinates with the servicer and legal counsel, and manages the closing process. This is not a DIY project.

Step 3: Get a preliminary cost estimate. The consultant models the securities portfolio and provides an estimated cost. This is rate-sensitive and will be updated closer to closing.

Step 4: Obtain servicer consent. The master servicer (or special servicer, if the loan is in special servicing) must approve the defeasance. This includes review of the successor borrower entity and the proposed securities portfolio.

Step 5: Purchase securities. On the closing date, the borrower funds the purchase of the Treasury portfolio. The securities are placed in a custodial account.

Step 6: Execute the substitution. The successor borrower assumes the loan. The original property is released from the mortgage. The securities become the new collateral.

Total timeline: 30 to 45 days from engagement to completion, though rushed transactions can close faster with additional fees.

Practical Tips for Brokers

If you are helping a client sell or refinance a property with a CMBS loan, defeasance will likely be part of the conversation. A few things worth knowing:

Get the cost estimate early. Defeasance cost can make or break a sale or refinance. If the defeasance premium eats the profit margin on a sale, the deal may not pencil. Run the numbers before the client lists the property, not after they are under contract.

Factor defeasance timing into the transaction calendar. A 30-45 day defeasance process running in parallel with a loan closing can create coordination challenges. Start the defeasance process as soon as the sale or refinance is likely to close.

The open window is the cheapest exit. If the client can wait until the last three to six months of the loan term, they can prepay at par with no penalty. Sometimes the economics of waiting are better than defeasance, even if it means holding the property a few extra months.

Check if the loan is assumable first. CMBS loans are generally assumable with servicer approval. If the buyer qualifies and is willing to assume the existing debt, there is no defeasance needed. Assumption typically costs $25,000 to $50,000 in processing fees, which is substantially less than defeasance.

Disclaimer: This glossary entry is for educational purposes only and does not constitute financial, legal, or investment advice. Defeasance costs and requirements vary by loan, servicer, and market conditions. Consult with a qualified defeasance consultant and legal counsel for advice specific to your transaction.

Frequently Asked Questions