What is Defeasance and How Does it Work?

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).