Defeasance

Defeasance is a prepayment strategy used primarily in commercial mortgage-backed securities (CMBS) loans that allows a borrower to release a property from its mortgage lien without paying off the loan balance directly. Instead of retiring the debt, the borrower purchases a portfolio of U.S. Treasury securities or government agency bonds whose cash flows precisely replicate the remaining scheduled loan payments, including principal, interest, and any balloon payment at maturity. This bond portfolio is then pledged as substitute collateral, and the original property is released free and clear of the mortgage.

The mechanical process involves several specialized parties. The borrower engages a defeasance consultant who models the required securities portfolio, coordinates with the loan servicer, and manages the transaction timeline. A successor borrower, typically a single-purpose entity (SPE), is created to assume the defeased loan obligation. The SPE holds the Treasury portfolio and makes the scheduled payments to the trust through maturity, while the original borrower walks away with the unencumbered property. The loan servicer and rating agencies must approve the substitution, and legal counsel issues opinions confirming the transaction satisfies the loan documents.

Defeasance applies almost exclusively to conduit CMBS loans and certain portfolio loans with defeasance provisions in their loan agreements. Most CMBS loans include a lockout period, typically the first two years after securitization, during which no prepayment of any kind is permitted. After the lockout expires, defeasance becomes available as the primary exit mechanism, usually until a window of 90 days before maturity opens for par prepayment.

The cost of defeasance varies substantially based on the interest rate environment. The borrower must purchase enough Treasuries to cover all remaining payments at current market yields. When prevailing Treasury rates are lower than the loan coupon rate, the cost premium is significant because the borrower must buy more securities (at higher prices) to generate sufficient cash flow. Total defeasance costs typically range from 1% to 10% or more of the outstanding loan balance, including the securities premium, legal fees of $25,000 to $75,000, accounting and consultant fees, and rating agency charges. When Treasury rates exceed the loan coupon, defeasance can occasionally be executed near par or even at a discount.

Defeasance differs fundamentally from yield maintenance, the other common CMBS prepayment mechanism. Yield maintenance is a cash penalty calculated as the present value of the interest rate differential over the remaining loan term, paid at the time of prepayment. The loan is retired entirely. Defeasance, by contrast, does not retire the loan. It substitutes collateral and transfers the obligation to a successor entity. The distinction matters because yield maintenance terminates the loan from the trust, while defeasance keeps the loan performing within the CMBS trust through maturity, which is why CMBS structures overwhelmingly prefer defeasance: it preserves the predictability of cash flows to bondholders.

Understanding defeasance is critical for any borrower holding CMBS debt who is considering a property sale, refinancing, or portfolio restructuring before loan maturity. Because CMBS loans cannot simply be prepaid with a standard penalty during most of the loan term, defeasance is often the only available exit path. Borrowers who fail to account for defeasance costs when underwriting an acquisition or modeling a hold period can face six- or seven-figure exit costs that fundamentally alter the economics of a transaction. A property sale negotiation that assumes a clean payoff, only to discover a $500,000 defeasance obligation, can collapse or require significant price adjustments.

Timing and interest rate awareness are the two most consequential strategic variables. Defeasance costs are inversely correlated with Treasury yields: when rates fall, costs rise dramatically because the borrower must purchase more expensive bonds to replicate the higher-coupon loan payments. Conversely, a rising rate environment can reduce defeasance costs substantially, sometimes making it economically attractive to exit a loan that would have been prohibitively expensive to defease a year earlier. Borrowers approaching a sale or refinance event should model defeasance costs under multiple rate scenarios and monitor Treasury yields actively as the transaction timeline progresses.

Strategic borrowers also evaluate whether defeasance or an alternative structure better serves their objectives. Some loan documents permit yield maintenance instead of or in addition to defeasance, and the relative cost of each depends on the rate environment and remaining loan term. Shorter remaining terms generally reduce defeasance costs because fewer securities are required. Borrowers within 12 to 18 months of maturity should compare the cost of defeasance against simply holding the property until the open prepayment window, which typically allows par payoff in the final 90 days. In some cases, the carrying cost of holding is less than the defeasance premium, making patience the superior financial decision.

• Underestimating total costs beyond the securities purchase. Borrowers focus on the Treasury portfolio premium but overlook legal fees, accounting charges, servicer processing fees, rating agency fees, and successor borrower setup costs. These ancillary costs can add $50,000 to $100,000 to the total, and they apply regardless of the interest rate environment.
• Failing to budget for defeasance at acquisition. Borrowers who acquire properties with existing CMBS debt, or who originate CMBS loans, frequently underwrite exit costs at zero or assume a simple prepayment penalty. When the hold period ends and defeasance is the only available mechanism, the unplanned cost compresses returns or forces a longer hold than intended.
• Initiating the process too late before a closing deadline. Defeasance transactions typically require 30 to 45 days from engagement to completion, involving servicer approvals, legal opinions, securities procurement, and successor borrower formation. Starting defeasance four weeks before a hard closing date on a property sale creates significant execution risk and may require expensive rate locks on the Treasury portfolio.
• Ignoring the open prepayment window near maturity. Most CMBS loans allow par prepayment during the final 90 days before maturity. Borrowers who defease with four or five months remaining may spend hundreds of thousands of dollars when waiting a few additional weeks would have allowed a par payoff. Always compare the defeasance cost against the carrying cost of holding through to the open window.
• Assuming defeasance costs are fixed once quoted. The securities portfolio price is tied to live Treasury yields, which move daily. A defeasance quote is a snapshot, not a commitment. Between the initial cost estimate and the actual securities purchase date, rate movements can increase or decrease the cost by tens of thousands of dollars. Borrowers should request updated quotes within days of the target execution date and consider whether a rate lock (available through some consultants) is warranted for large transactions.