How it works
Defeasance exists because of how CMBS loans are owned. A conduit loan is pooled with others and sold to bondholders, whose returns depend on receiving the scheduled payments. Simply prepaying would disrupt those cash flows and create tax problems for the trust. Defeasance solves this by replacing the source of the payments while leaving the payments themselves entirely intact: the bondholders continue receiving exactly what they expected, now funded by Treasuries rather than by rent.
The mechanics are substitution rather than repayment. The borrower buys a portfolio of government securities structured so that its principal and interest exactly match the loan's remaining payments, including the balloon. Those securities are pledged to a successor borrower entity that assumes the loan. The original borrower walks away, the property is released, and the loan continues to maturity.
Cost is dominated by the same rate relationship that governs yield maintenance, in the same direction. If Treasury yields are below the loan rate, the securities needed to produce the required payments cost more than the loan balance, sometimes far more, and the excess is the borrower's cost. If Treasury yields exceed the loan rate, the portfolio can cost less than the balance, producing the rare situation of positive defeasance, where the borrower recovers cash on exit.
Defeasance also carries meaningful transaction costs and complexity that yield maintenance does not: a defeasance consultant, an accountant's verification of the cash flows, rating agency confirmation, legal fees for the successor borrower, and several weeks of process. These commonly run $50,000 to $100,000 or more and must be built into the closing timetable of any sale or refinance involving a CMBS loan.
Worked example
A CMBS loan with a $5,000,000 balance at 6.5% and four years remaining is defeased. Compare a 4.0% Treasury environment with a 7.0% one.
| Step | Calculation | Result |
|---|---|---|
| Remaining payments to replicate | four years of debt service plus the balloon | scheduled cash flows |
| Cost of the securities portfolio at 4.0% yields | payments discounted at 4.0% | approximately $5,450,000 |
| Defeasance premium over the balance | $5,450,000 − $5,000,000 | $450,000 |
| Cost of the portfolio at 7.0% yields | payments discounted at 7.0% | approximately $4,910,000 |
| Result at 7.0% | $4,910,000 against a $5,000,000 balance | $90,000 positive |
| Transaction costs in either case | consultant, accountant, legal, rating agency | $50,000 – $100,000 |
In a falling-rate environment the borrower pays roughly $450,000 above the balance plus transaction costs to release the property. In a rising-rate environment the portfolio costs less than the loan balance, and the borrower can recover around $90,000 before costs. This is why CMBS borrowers who bought at low rates and are selling into a higher-rate market often find the exit cheaper than expected: the mechanism that punishes them when rates fall rewards them when rates rise.
Common mistakes
- Confusing defeasance with prepayment
- The loan is not repaid. It stays outstanding and continues paying from a securities portfolio, with the property released from the lien.
- Underestimating the timeline
- Defeasance typically takes several weeks and involves multiple third parties. A sale contract with a short closing period can fail on process alone.
- Omitting transaction costs from the exit analysis
- Consultant, accounting, legal and rating agency fees commonly total $50,000 to $100,000 regardless of the securities cost.
- Assuming defeasance is always expensive
- When Treasury yields exceed the loan rate, the portfolio can cost less than the outstanding balance.
Frequently asked questions
- What is defeasance in commercial real estate?
- A mechanism used to release a property from a CMBS mortgage by substituting a portfolio of government securities as collateral. The loan remains outstanding and continues paying on schedule from the securities, while the borrower takes the property free of the lien.
- How much does defeasance cost?
- It depends on the relationship between Treasury yields and the loan rate. When Treasury yields are below the loan rate the securities cost more than the outstanding balance, sometimes by several percent. When they exceed it, the portfolio can cost less. Transaction costs of roughly $50,000 to $100,000 apply in either case.
- What is the difference between defeasance and yield maintenance?
- Yield maintenance is a cash penalty that compensates the lender for lost interest, after which the loan is repaid and retired. Defeasance does not repay the loan at all; it replaces the collateral with securities that continue making the scheduled payments.