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What Is Defeasance?
Defeasance is a strategy that permits repayment of a commercial property loan on a property, to facilitate sale or refinance.
Paying Off a Commercial Real Estate Loan Early Through Defeasance
Defeasance is a strategy that permits the repayment of a commercial real estate loan on a property in order to facilitate the property’s sale or refinance. Many securitized mortgages are packaged to create investment products called commercial mortgage-backed securities (CMBS). Because the stability of these products depends on the guaranteed return of the investment from the interest charged over the original term of the loan, prepayment is generally prohibited.
Defeasance is the replacement of the loan proceeds with government-backed securities such as treasury bonds, that offer the same return. The security offered by the defeasance process must promise enough cash flow to pay the original commercial property loan's interest and principal so that the lender does not end up with less money than if the loan had remained intact.
The result is that the borrower can pay off the commercial mortgage loan early and sell the property without a lien transferred to the buyer. The securities are transferred to a successive borrower, who can make an additional profit off the transaction.
How Do Borrowers and Lenders Benefit from Defeasance?
In general, defeasance can be highly beneficial to borrowers, as it involves the substitution of a riskier asset (a commercial real estate loan) with a much safer asset (typically U.S. Treasury bonds). And, for borrowers, defeasance can be helpful as well, as it allows them to get out of a loan early, freeing up their capital for investment opportunities that may generate a higher yield than their original commercial property.
Borrowers Typically Require Experts to Assist With Defeasance
Since the defeasance process is complex and time-consuming, most borrowers considering defeasance will usually hire a team of defeasance consultants in order to help them complete defeasance with as little hassle as possible. This often includes bond buyers, lawyers, and sometimes even tax experts (fortunately for borrowers, defeasance is tax deductible.) Interestingly enough, defeasance consultants may not always recommend defeasance; depending on the circumstances and going Treasury rates, it may actually be a better choice to avoid prepaying the loan altogether.
Whether defeasance is a good idea also depends on the specific defeasance terms outlined in a borrower’s loan agreement. For example, defeasance is more ideal when a lender allows a borrower to use agency bonds, and less ideal when they need to use Treasury bonds.
Yield Maintenance vs. Defeasance
For CMBS loans and certain other types of commercial mortgages, yield maintenance is the main alternative to defeasance. Yield maintenance permits a lender to gain the same yield that they would if a borrower was not prepaying the loan. In general terms, yield maintenance is repaying a loan early with a penalty covering all future interest, while defeasance is actually substituting the loan’s collateral with another income generating asset. Some CMBS and conduit loans (as well as some other kinds of securitized debts) may actually allow borrowers to choose between yield maintenance or defeasance.
Yield maintenance is generally more favorable to a borrower when Treasury rates are not compounded monthly and payments are calculated to the prepayment date with a lower prepayment penalty (usually 1%). However, if Treasury rates are compounded monthly and payments are calculated to the maturity date (and a higher prepayment penalty, say 3%, is levied), defeasance may be a better idea.
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What is the definition of defeasance in commercial real estate?
Defeasance is a common type of prepayment penalty for CMBS loans and even certain types of Fannie Mae and Freddie Mac multifamily financing. The defeasance process replaces the collateral of a loan with securities which provide the lender with an equivalent return. Usually, defeasance involves fixed-rate government bonds.
What are the benefits of using defeasance in commercial real estate?
Defeasance in commercial real estate can provide a number of benefits for both the lender and the borrower. For the lender, defeasance removes any risk of repayment and replaces it with returns guaranteed by U.S. Treasury bonds (or, in some cases, bonds issued by Fannie Mae, Freddie Mac, or Ginnie Mae).
From the borrower's perspective, defeasance can be particularly advantageous for notes with a variable rate, as it removes the need to be concerned with rising rates. Defeasance can also have accounting benefits, as it removes the debt from the company's balance sheet, making it less complex when it comes to logging debt service transactions.
How does defeasance work in commercial real estate?
Defeasance in commercial real estate is a process that allows a borrower to pay off a loan without incurring a prepayment penalty. The process involves replacing the loan with a portfolio of bonds that generate the same cash flow as the loan. This process is complex and requires a team of experienced accountants and legal experts to execute it successfully. It also requires a significant capital investment into the replacement collateral, which are the bonds used to offset the yields. A defeasance consultant is typically hired to conduct the entire process, which includes purchasing the exact amount of bonds, securing them in a custodial account, and filing the necessary paperwork for tax purposes.Sources: Defeasance or Yield Maintenance: Which Is Better? What is Defeasance and How Does it Work?
What are the risks associated with defeasance in commercial real estate?
The main risks associated with defeasance in commercial real estate come down to cost. The process is generally so complex that a team of experienced accountants and legal experts are required to execute everything successfully. As these aren’t single-day transactions — and can take months, depending on the situation — this time factor can make the process itself prohibitively expensive. Additionally, beyond the staff requirements, defeasance’s costs are also increased by the intensive capital investment into the replacement collateral — the bonds — used to offset the yields.
For the borrower, there are also some risks to defeasance, but they broadly depend on a borrower’s specific situation and wider economic conditions and trends. If interest rates are expected to rise, defeasance can be particularly disadvantageous for loans with a variable rate. By replacing the loan’s collateral with bonds, a borrower may not be able to take advantage of the lower rates.
What are the costs associated with defeasance in commercial real estate?
The main disadvantages of defeasance come down to cost. The truth is that defeasance can be extremely expensive. First, the process is generally so complex that a team of experienced accountants and legal experts are required to execute everything successfully. As these aren’t single-day transactions — and can take months, depending on the situation — this time factor can make the process itself prohibitively expensive. Second, beyond the staff requirements, defeasance’s costs are also increased by the intensive capital investment into the replacement collateral — the bonds — used to offset the yields.
In addition, a certain amount of negotiation and communication with the lender will typically be required throughout the entire process. For instance, while defeasance is tax-deductible, a borrower (or their original accountant) may not be used to filing the type of paperwork and documentation required for a borrower to take the deduction.
What are the alternatives to defeasance in commercial real estate?
The main alternative to defeasance in commercial real estate is yield maintenance. Yield maintenance is a prepayment penalty that is designed to compensate the lender for the loss of interest income that would have been earned if the loan had been paid off over its full term. Yield maintenance is calculated by taking the difference between the loan’s original interest rate and the current market rate, multiplied by the remaining principal balance of the loan. This amount is then paid to the lender as a penalty for early repayment.
Yield maintenance is generally less expensive than defeasance, as it does not require the borrower to purchase replacement collateral. However, it does not provide the same level of certainty as defeasance, as the penalty amount is subject to market fluctuations.