Defeasance

Defeasance is one of two primary prepayment protection mechanisms used in CMBS and commercial mortgage loans in the United States — the other being yield maintenance. Its purpose is to allow a borrower to sell or refinance a property that secures a fixed-rate commercial loan while fully compensating the lender for the interest income they would have received had the loan remained outstanding through maturity.

The defeasance mechanism works as follows. When a borrower wishes to prepay a defeased loan, they engage a defeasance consultant and purchase a carefully constructed portfolio of U.S. Treasury securities, agency securities, or other eligible government instruments. This portfolio is structured so that the scheduled maturities and coupon payments from the securities will exactly match every remaining principal and interest payment due under the loan through its maturity date. The security portfolio is placed into a special purpose entity that assumes the loan obligations, and the real property is released from the mortgage lien. The borrower is then free to sell the property or use it as collateral for new financing.

The cost of defeasance depends on the relationship between the loan's interest rate and prevailing Treasury yields at the time of defeasance. When Treasury yields are low relative to the loan coupon — as was common during the low-rate environment of 2010-2021 — the cost of purchasing the required Treasury portfolio can be substantial, since Treasury securities pay lower yields than the loan rate and therefore more principal is required to generate the same payment stream. When Treasury yields rise closer to or above the loan coupon, the cost of defeasance declines significantly.

Defeasance is generally preferred by lenders over yield maintenance because it eliminates all uncertainty about the lender's yield — the substituted securities literally pay out the same cash flows. For CMBS trusts, defeasance has the additional benefit of maintaining the investment's tax treatment under the REMIC (Real Estate Mortgage Investment Conduit) structure that governs CMBS securitizations, since REMIC rules impose restrictions on the modification of mortgage loans.

Borrowers evaluating a sale or refinancing of a commercially mortgaged property should analyze the defeasance cost early in the planning process, as it can represent a significant transaction cost — sometimes running to millions of dollars on large loans — that materially affects the net proceeds from a sale. Real estate attorneys and defeasance consultants specializing in this area can model defeasance costs at any point in a loan's life based on current Treasury yields.