Definition
Defeasance is a prepayment mechanism commonly used in CMBS loans that allows a borrower to effectively pay off a loan without directly retiring it. Instead of repaying the loan balance in cash, the borrower replaces the original real estate collateral with a portfolio of government securities that generate the same scheduled cash flows as the remaining loan payments.
Why Defeasance Exists
CMBS loans are securitized into bonds sold to investors who expect predictable cash flows. Traditional prepayment would disrupt those payments. Defeasance preserves the bondholder’s income stream while releasing the property from the lien.
How the Process Works
- The borrower requests defeasance, typically after a lockout period.
- A defeasance consultant structures a portfolio of U.S. Treasury securities.
- The securities are placed into a successor borrower entity.
- The property is released from the mortgage lien.
- The securities continue making scheduled payments to the trust.
Cost Considerations
- Yield maintenance effect: Cost depends on interest rate movements.
- Transaction fees: Legal, accounting, rating agency, and consultant costs.
- Spread environment: Lower Treasury yields increase defeasance cost.
If interest rates fall below the loan coupon, defeasance can be expensive because the borrower must purchase more securities to replicate higher loan payments.
Defeasance vs. Yield Maintenance
- Defeasance: Replaces collateral with securities.
- Yield Maintenance: Pays a penalty calculated to preserve lender yield.
Both mechanisms aim to protect bondholders or lenders from reinvestment risk.
Investor Implications
- Exit timing: Sale decisions should factor defeasance cost.
- Refinance strategy: Rate environment significantly impacts payoff cost.
- Capital planning: Unexpected rate drops can materially increase exit friction.
- Structuring awareness: Understand lockout periods and substitution provisions.
Example
A borrower has a $20M CMBS loan at 5.5% with 4 years remaining. Current Treasury yields are 3.5%. To replicate the higher coupon, the borrower must purchase additional securities, increasing the effective payoff cost above $20M plus transaction expenses.
Common Pitfalls
- Ignoring timing windows: Some loans have strict lockout periods.
- Underestimating fees: Professional costs can be substantial.
- Not modeling rate sensitivity: Defeasance cost fluctuates with Treasury yields.
- Assuming flexibility: CMBS structures are highly procedural.