Defeasance is a prepayment mechanism, common in CMBS and other fixed-rate CRE loans, that releases the property from the mortgage lien by substituting a portfolio of U.S. government securities (typically Treasury STRIPS) whose cash flows replicate every remaining scheduled loan payment. The loan is not paid off; the real estate collateral is replaced with risk-free securities.
How does defeasance work?
Securitized loans cannot simply be prepaid without disrupting the cash flows promised to bondholders. Defeasance solves that problem. The borrower buys a precise portfolio of Treasuries whose cash flows exactly match every remaining loan payment through maturity, and those securities take the place of the property as collateral. The loan continues to exist and keeps paying investors on schedule.
The transaction is one of the most complex and expensive in CRE debt. It typically requires a team that includes a defeasance consultant, a securities broker, a successor borrower, and rating agency approval. Start to finish, the process takes 30 to 45 days.
What does defeasance cost?
The cost depends on the difference between the loan’s coupon rate and current Treasury rates. When Treasuries yield less than the loan rate, the securities needed to fund the remaining payments cost more than the loan balance, and defeasance is expensive. When Treasuries yield more than the loan rate, the portfolio costs less, and defeasance can be relatively cheap or even result in a premium to the borrower.
Defeasance cost = price of the Treasury portfolio that replicates the remaining loan payments, minus the outstanding loan balance, plus transaction fees
Illustrative example (round numbers, fees excluded):
| Input | Value |
|---|---|
| Outstanding loan balance | $10,000,000 |
| Loan coupon | 5.00%, interest-only, balloon in 3 years |
| Payments to replicate | $500,000 per year for 3 years, plus $10,000,000 at maturity |
| Portfolio cost if Treasuries yield 3.00% | about $10,570,000 (a premium of about $570,000) |
| Portfolio cost if Treasuries yield 6.00% | about $9,730,000 (below the loan balance) |
Because Treasury rates move daily, the cost of defeasance changes every day. Borrowers considering a sale, refinance, or recapitalization of a property with a defeasable loan need to model the cost well in advance and monitor it regularly.
When can a borrower defease a loan?
Many borrowers are surprised to learn that their defeasance window does not open until two years after origination. Certain CMBS deals also carry unique structural requirements, so the loan documents govern the timing and mechanics for each loan.
Timing matters enormously. The securities are priced on the day they are purchased, so a borrower planning a sale or refinance should know the eligibility date, the open period, and the estimated cost long before the transaction closes. A loan approaching its maturity date has fewer payments left to replicate, which changes the math again.
How defeasance shows up in LoanBoss
LoanBoss calculates defeasance and yield maintenance costs in real time, with the ability to project prepayment costs for future dates. Every prepayment convention in the loan documents is reflected in each loan, and the platform tracks defeasance eligibility dates and open periods so borrowers can decide when to act.
Frequently Asked Questions
Does defeasance pay off the loan?
No. The loan continues to exist and keeps making its scheduled payments to investors. Only the collateral changes: the property is released from the lien and a portfolio of U.S. government securities takes its place.
Why does defeasance exist?
Securitized loans cannot simply be prepaid without disrupting the cash flows promised to bondholders. Defeasance lets the borrower exit the property while the bondholders keep receiving exactly the payments they were promised.
When is defeasance expensive?
When Treasury yields are below the loan’s coupon rate. The securities needed to replicate the remaining payments then cost more than the loan balance. When Treasury yields are above the coupon, defeasance can be relatively cheap or even produce a premium to the borrower.
How long does defeasance take?
Typically 30 to 45 days. The process involves a defeasance consultant, a securities broker, a successor borrower, and rating agency approval, along with the purchase of a Treasury portfolio matched to every remaining payment.
When can a CMBS loan be defeased?
The defeasance window typically does not open until two years after origination, and certain CMBS deals carry unique structural requirements. Check the loan documents for the eligibility date and open period before planning a sale or refinance.
Related Terms
- CMBS
- Maturity Date
- Amortization
- Interest Rate Swap
- Yield Maintenance
- Defeasance Decisions in Portfolio Context: When Does It Make Sense?
- Tracking CMBS Loans as a Borrower: Servicers, Cash Management and Defeasance
Part of the LoanBoss CRE Debt Glossary. For hedging-specific terms, see Pensford’s resources.
Sources
- LoanBoss CRE Debt Glossary