What is Defeasance and How Does it Work?
Defeasance refers to the replacement of the collateral of a loan with securities (generally fixed-rate government bonds) that will offer a lender an equivalent return. In many cases, borrowers will need to purchase U.S. Treasury bonds to conduct defeasance, though other types of government-backed securities may be used in some scenarios.
- Defeasance as a Prepayment Penalty for Multifamily and Commercial Real Estate Loans
- Defeasance Generally Requires Expert Consultants
- When Is Defeasance a Good Idea?
- Deciding on Defeasance vs. Yield Maintenance
- Yield Maintenance Calculator
- Defeasance Clause in Real Estate
- Defeasance Clause vs Prepayment Penalty
- Related Questions
- Get Financing
Defeasance as a Prepayment Penalty for Multifamily and Commercial Real Estate Loans
In the multifamily and commercial financing industry, there are a variety of ways that a borrower can potentially reimburse their lender for prepaying their loan. Common prepayment penalties include yield maintenance, step-downs, and soft-step downs. However, defeasance, another common type of prepayment penalty, is also often an option, particularly for CMBS loans, as well as for certain Fannie Mae® and Freddie Mac® multifamily loans.
Defeasance refers to the replacement of the collateral of a loan with securities (generally fixed-rate government bonds) that will offer a lender an equivalent return. In many cases, borrowers will need to purchase U.S. Treasury bonds to conduct defeasance, though other types of government-backed securities may be used in some scenarios. The important aspect is that the bonds, as a whole, provide at least the same amount of income as did the loan itself. That way, the lender will not experience any loss of income as a result of the borrower prepaying their loan. In most scenarios, a borrower opts to prepay their loan due to the fact that they want to sell the property before the term of the loan is up.
Defeasance Generally Requires Expert Consultants
Just like a commercial or multifamily real estate investor involved in litigation would generally rather hire a lawyer than representing themselves in court, most borrowers who want to defease their loan will generally hire a defeasance consultant to conduct the entire process for them. While the concept may sound simple, defeasance, overall, can be somewhat complex. The exact amount of bonds must be purchased, secured in the proper way (typically a custodial account), and recorded and filed property for tax purposes. 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.
When Is Defeasance a Good Idea?
Depending on current interest rates and other factors, defeasance may or may not be the best idea for a commercial or multifamily real estate borrower. If market interest rates increase beyond the rate of the mortgage, a borrower may actually profit from defeasance. The exact defeasance terms allowed by a lender will also impact whether defeasance is a smart move for a borrower. For example, it’s usually significantly less expensive for a borrower to defease a mortgage utilizing Freddie Mac, Fannie Mae, or Ginnie Mae bonds than it is to defease a loan using U.S. Treasury bonds.
As you can see, whether defeasance is best for an individual borrower depends on their individual situation; however, defeasance is almost universally a good idea for lenders. This is because bonds present a significantly lower prepayment risk than do commercial or multifamily mortgages. While a borrower may default due to low occupancy rates, legal issues, fraud, or a variety of other issues, it would take a true economic cataclysm for the U.S. Treasury, Fannie or Freddie to stop paying the yield on their bonds. Generally, a defeasance consultant will be able to give you a no-cost estimate to determine whether it's ideal for you or not.
Deciding on Defeasance vs. Yield Maintenance
In many cases, a borrower will have to choose between yield maintenance and defeasance as loan prepayment penalties. This is often the case when it comes to CMBS loans. Choosing between these two options also depends on the exact terms of a lender’s defeasance agreement. Defeasance is usually the optimal choice when bond interest rates are compounded monthly and payments are calculated to the maturity date (and when the overall yield maintenance prepayment penalty is greater). In contrast, yield maintenance is typically more optimal if bond interest rates are compounded annually and payments are calculated to the loan’s prepayment date (and when the overall yield maintenance prepayment penalty is smaller).
Yield Maintenance Calculator
Defeasance Clause in Real Estate
A defeasance clause in a mortgage is a provision that allows a borrower to pay off their outstanding loan without penalty or additional fees. This clause is commonly found in commercial real estate loans and can provide significant benefits for borrowers who wish to refinance their loan or sell their property.
Defeasance clauses are typically included in commercial real estate loans as a way to protect the lender's interests. If a borrower defaults on their loan, the lender can use the property as collateral to recoup their losses. However, if a borrower wishes to pay off their loan early, the defeasance clause allows them to do so without incurring any additional costs or penalties.
Secondly, a defeasance clause can also be beneficial for borrowers who wish to sell their property. If a property is sold before the loan is paid off, the buyer may not be willing to assume the existing loan. In this case, the defeasance clause allows the borrower to pay off the loan and transfer the property to the new owner without any additional costs or penalties.
Defeasance Clause vs Prepayment Penalty
It is important to note that a defeasance clause is not the same as a prepayment penalty. A prepayment penalty is a fee that is charged to a borrower who pays off their loan early, whereas a defeasance clause allows a borrower to pay off their loan without incurring any additional fees.
In conclusion, a defeasance clause in a commercial real estate loan can provide significant benefits for borrowers who wish to refinance their loan or sell their property. This clause allows borrowers to pay off their loan without incurring any additional costs or penalties, providing them with the flexibility to take advantage of lower interest rates or sell their property without any additional financial burdens.
Related Questions
What is the difference between defeasance and yield maintenance?
- The main difference between defeasance and yield maintenance is that defeasance involves replacing the collateral of a loan with securities (generally fixed-rate government bonds) that will offer a lender an equivalent return, while yield maintenance involves the borrower paying a penalty to the lender in order to prepay the loan.
Is defeasance always the best option for a borrower?
- Whether defeasance is best for an individual borrower depends on their individual situation; however, defeasance is almost universally a good idea for lenders. This is because bonds present a significantly lower prepayment risk than do commercial or multifamily mortgages.
How defeasance can help me refinance my loan?
- Defeasance can help you refinance your loan by allowing you to pay off your existing loan without incurring any additional costs or penalties. This can be beneficial if you are looking to take advantage of lower interest rates or if you are looking to sell your property.
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.
Source: https://www.commercialrealestate.loans/commercial-real-estate-glossary/the-strategy-of-defeasance
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 government or corporate bonds that generate the same cash flow as the loan. The borrower must purchase the bonds, secure them in a custodial account, and record and file them for tax purposes. A defeasance consultant is typically hired to conduct the entire process, as it can be complex and require negotiation and communication with the lender. Source 1 and Source 2.
What are the benefits of defeasance in commercial real estate?
Defeasance in commercial real estate can provide several 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 if interest rates are expected to rise, as it replaces the loan's collateral with bonds and the borrower doesn't 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.
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 steps involved in a defeasance transaction?
The steps involved in a defeasance transaction typically include:
- Hiring a defeasance consultant to conduct the entire process
- Purchasing the exact amount of bonds
- Securing the bonds in a custodial account
- Recording and filing the bonds for tax purposes
- Negotiating and communicating with the lender
- Retaining a defeasance consulting company to help minimize costs
- Working with an experienced broker-dealer to tailor a pool of securities
- Securing a securities intermediary to hold the bonds in a separate account
- Making monthly debt payments to the lender with the cash proceeds from the securities
- Optimizing the portfolio of securities to match the value of the remaining debt service payments
- Adhering to legal and industry standards
For more information, please see What is Defeasance and How Does it Work? and Defeasance for CMBS Loans.
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.