Defeasance
Defeasance is a way to release a commercial property from its mortgage lien before maturity while the loan’s scheduled payments keep flowing to the lender and to the investors in the securitization. The borrower buys a portfolio of securities, traditionally U.S. government securities, whose cash flows match the remaining payments on the loan. The debt stays in place and the securities service it, so the property is freed and the payment stream is untouched.
What changes and what stays the same in a defeasance
Defeasance swaps the collateral and leaves the debt alone. The borrower delivers substitute securities sized to match the lender’s scheduled payments, and once they are in place the property comes out from under the mortgage lien.
That is why it works inside a securitized loan. The investors in the trust bought a defined stream of payments, and the replacement securities deliver that stream. A defeased loan is a refinancing of the remaining balance with government securities by agreement between borrower and lender, and it carries consequences for the bondholders in any deal that holds the loan.
Some agency lending programs let the borrower elect defeasance at origination as the route to an early lien release, with agency or Treasury securities posted as the collateral.
A payoff retires the debt. A defeasance retires only the lien.
Why a lockout makes defeasance the exit route
Prepayment of securitized debt is almost universally prohibited until the last 60 to 90 days of the loan term. The trust is built on predictable cash flow, so the loan documents close the ordinary payoff door for nearly the whole term.
Defeasance is the usual way to get a lien release before that window opens. A borrower who needs to sell or refinance in year four of a long fixed rate loan has no prepayment right to use, so the question becomes what the substitute portfolio costs.
The terms of the loans themselves point the same direction. Term loans from life insurance companies and CMBS sources usually run 10 years or more at fixed rates and are commonly nonrecourse. In the Freddie K market, 10 year loans typically carry a 9.5 year lockout or defeasance period, which leaves very little open time before maturity.
“In order to ensure the predictability and consistency of cash flow to the REMIC trust, prepayment of CMBS debt is almost universally prohibited until the last 60-90 days of the loan term.”
Defeasance versus yield maintenance as early exit pricing
Both defeasance and yield maintenance can require an early-payoff borrower to make the lender whole on a securitized loan. They get there by different routes.
Defeasance asks the borrower to supply substitute security matching the lender’s scheduled payments. The borrower buys an asset and delivers it. Yield maintenance is a prepayment charge. The two produce a comparable economic result for a borrower who wants out early, and the documents decide which one applies.
Borrowers like ten-year money, but the rigidity of yield maintenance draws complaints. Defeasance has its own rigidity, because the cost is set by securities prices on the day of purchase.
Why falling rates raise the cost of the portfolio
The portfolio must produce every scheduled payment, so its cost is the market price of those cash flows. When interest rates fall, Treasury bond prices rise, and the same stream of payments costs more to replicate.
A borrower holding a fixed rate loan above current Treasury yields therefore pays a premium over the loan balance. The lower rates go, the larger that premium becomes.
The balloon matters here. Commercial loans rarely amortize fully, so the balloon at maturity is often 80 to 90 percent of the original balance. Most of the portfolio is then a single large payment at the end of the schedule, and that payment is the part most sensitive to the discount rate.
“Bond prices increase when interest rates fall, so the government Treasurys purchased for a defeasance portfolio are more expensive now.”
Why rating criteria cap pools with heavy defeasance
Once a loan defeases, its credit support becomes the government securities held in place of the property. The pool’s credit profile then depends on the sovereign, and rating criteria reflect it.
When defeasance is more than 50 percent of a CMBS asset pool, classes will typically be rated no higher than two notches above the long-term issuer default rating of the relevant sovereign. A single-borrower loan that is fully defeased is the usual case that crosses the threshold, and the cap may be waived in some circumstances.
Worked example: defeasing a hypothetical $10 million loan ahead of a sale
The hypothetical loan has a $10,000,000 balance, a 6 percent fixed rate with interest-only payments, and 5 years remaining. The property sells for $16,000,000. Taxes and sale costs are left out so that only the defeasance cost moves between cases.
Annual interest is $10,000,000 multiplied by 0.06, or $600,000. Over 5 years that is $600,000 multiplied by 5, or $3,000,000 of interest. Adding the $10,000,000 balloon gives $13,000,000 of total scheduled payments for the portfolio to cover.
In the base case the Treasury-based portfolio prices at 0.88 per dollar of scheduled payments. Portfolio cost is $13,000,000 multiplied by 0.88, or $11,440,000. That is $1,440,000 above the loan balance. With $150,000 of defeasance fees, total cost is $11,590,000, and sale proceeds left after defeasance are $16,000,000 minus $11,590,000, or $4,410,000.
In the lower-rate case, everything else matches the base case and the portfolio prices at 0.90 per dollar. Portfolio cost is $13,000,000 multiplied by 0.90, or $11,700,000, which is $1,700,000 above the balance. Adding the same $150,000 of fees gives $11,850,000, and proceeds left are $16,000,000 minus $11,850,000, or $4,150,000.
The rate move raises the portfolio cost by $11,700,000 minus $11,440,000, or $260,000. Remaining proceeds fall by $4,410,000 minus $4,150,000, the same $260,000. The pricing factors are illustrative inputs and not a quote.
Common defeasance mistakes in analysis and documents
The cost of release depends on securities prices and transaction fees, not just the loan balance. The portfolio replicates scheduled interest and the balloon, so a loan with an above-market coupon costs more than its balance to defease. In the hypothetical case the portfolio runs $1,440,000 above a $10,000,000 balance before fees.
Pricing the portfolio once and holding the figure fixed ignores the rate sensitivity. Treasury prices rise as rates fall, so an estimate from early in a sale process can be stale by closing. A 0.02 move in the pricing factor in the example shifts cost by $260,000.
Assuming a prepayment right exists mid-term misreads the structure. Prepayment is shut off for nearly the whole term, so a borrower who wants out early cannot simply repay and must either hold the loan to the final 60 to 90 days or replace the collateral through defeasance, and analyses that model a cash payoff in the middle years describe an option the loan documents do not give.
Treating defeasance and yield maintenance as the same cost measures a different thing. One is a securities purchase sized to the payment schedule, the other a prepayment charge, and the loan documents decide which applies.
Reading a defeased loan as a credit event for the property mixes up two things. The lien is gone and the securities carry the payments. For rating purposes, a pool with more than 50 percent defeased collateral faces the sovereign-linked cap.
Questions a defeasance analysis should answer
Do the loan documents permit defeasance for this release? The permitted release routes and conditions sit in the agreement.
What payments must the replacement portfolio match? The remaining schedule, including the balloon, defines the cash flows.
When does a payoff window open, and what applies before it? Prepayment is almost universally barred until the last 60 to 90 days of the term.
How is the portfolio priced and when is the price set? Treasury prices rise when rates fall, so the date of purchase matters.
What fees sit outside the securities purchase? Total cost combines the portfolio and the transaction fees.
How large is the premium over the loan balance? A coupon above Treasury yields pushes portfolio cost above the balance.
Does the loan’s lockout end well before maturity? Some 10 year loans carry a 9.5 year lockout or defeasance period.