Defeasance

Definition

Defeasance in real estate is a financial and legal process that lets a borrower—most commonly in commercial real estate—remove a lender’s lien and effectively pay off or refinance a loan early by substituting the original property collateral with low‑risk assets (typically U.S. Treasury or agency bonds) that generate the same cash flows the lender expected from the loan. This lets the borrower avoid prepayment penalties while preserving investors’ expected returns.

How defeasance works

• Defeasance clause: A mortgage or loan agreement often contains a clause that explains when the borrower obtains full ownership—generally when loan terms are satisfied. Until then, the lender retains a security interest.
• Substitution of collateral: Instead of paying the loan off in cash, the borrower (or a trustee) buys a portfolio of government or agency securities whose scheduled payments match the remaining loan payments. That portfolio replaces the mortgage lien.
• Result: The borrower is released from loan obligations, the lender continues to receive the expected cash flows from the substitute assets, and the property is free of the lender’s lien—allowing sale or refinancing.

Why defeasance is used

Defeasance is commonly used to bypass early‑repayment restrictions and prepayment penalties associated with securitized loans—especially commercial mortgage‑backed securities (CMBS) and fixed‑rate commercial mortgages—so borrowers can sell or refinance without disrupting investor returns.

Real‑world examples

1. Sale or refinance of a commercial property: A property owner wants to sell but holds a CMBS loan with heavy prepayment costs. Instead of paying a penalty, the owner purchases Treasury securities that replicate the loan’s payment stream and substitutes them as collateral, freeing the property for sale.
2. Investor strategy: An investor who frequently pays off loans negotiates defeasance rights. When exiting an asset, the investor substitutes government bonds for the mortgage lien to avoid prepayment penalties and preserve returns.
3. Corporate liability management: Corporations may defease debt for accounting purposes by placing low‑risk assets to cover obligations, allowing removal of liabilities from the balance sheet without immediate cash repayment.
4. Multifamily and commercial markets: Large multifamily and commercial loans are often defeased to enable owners to refinance or reposition assets while maintaining required cash flows to CMBS investors.

Benefits

When defeasance might not be ideal

Defeasance can involve significant transaction costs (legal, trustee, and bond purchase fees) and complex documentation. Some loans explicitly prohibit defeasance, or the economic cost of buying a replicating bond portfolio may outweigh the benefit of avoiding a prepayment penalty. Evaluate alternatives like loan assumption, partial prepayment, or negotiation with the lender.

Quick summary

Defeasance is a specialized substitute‑collateral method that frees commercial real estate borrowers from loan liens without breaking the lender’s expected cash flows. It balances borrower flexibility (sell or refinance) with investor protection (continuous payments), making it a common tool in CMBS and other fixed‑rate commercial lending.