What actually happens in a defeasance
Defeasance is not a payoff. The loan you signed stays alive, keeps its original rate and its original maturity date, and keeps paying the bondholders who own it. What changes is the collateral standing behind it.
- A defeasance consultant assembles a portfolio of US Treasury and agency securities whose interest and principal payments land on the same dates, in the same amounts, as your loan's remaining payments — including the balloon at maturity.
- You buy that portfolio at closing, out of your sale or refinance proceeds.
- The portfolio is pledged to the lender as substitute collateral, and the loan is assigned to a successor borrower: a bankruptcy-remote shell entity created for exactly this purpose.
- The lien on your building is released. You own the property free of the mortgage; the successor borrower holds the loan and the securities that now service it.
This is why defeasance is the standard exit in CMBS loans. Those loans are pooled and sold to bond investors who were promised a specific stream of payments through a specific date. Letting one borrower prepay would break that promise, so the documents forbid prepayment outright and offer collateral substitution instead.
Worked example
A $5,000,000 CMBS loan at 5.30%, interest only, with five years left to maturity. The securities portfolio has to cover 60 monthly interest payments of $22,083 plus the $5,000,000 balloon.
- Treasury yields near 3.90% — that payment stream costs roughly $5,318,000 to buy, about $318,000 more than you owe.
- Treasury yields near 5.90% — the identical stream costs roughly $4,870,000, about $130,000 less than you owe.
- Transaction costs, in either case — defeasance consultant, accountant verification of the portfolio, successor borrower fee, servicer and rating agency review, and legal work on both sides. On a loan this size these commonly total somewhere in the $40,000 to $100,000 range, and they are separate from the securities themselves.
In the first case, adding roughly $60,000 of fees to the $318,000 premium puts the cost of getting out at about $378,000 — a little over 7% of the balance. In the second case the securities cost less than the debt they replace, and after fees you land close to break-even. Same loan, same documents, opposite answer. The Treasury curve decided it. Run your own balance and remaining term through the defeasance calculator before you assume either outcome.
What it means for you
The line item to plan around is not the fee. It is the calendar. A defeasance takes 30 to 45 days and involves five or six parties who all bill you, and none of them can start until the servicer opens the file. A purchase contract with a 30-day close and a defeasance requirement is a contract that will not close on time.
Call the servicer the week you decide to sell or refinance, not after you have a signed agreement. If you are refinancing out of a CMBS loan, run the new loan in parallel — apply for the replacement financing while the defeasance is being priced, because the two timelines have to converge on one closing date and neither one waits for the other.
What to watch for
- Lockout comes before everything. Most CMBS loans prohibit any exit at all for the first two to four years. During lockout, defeasance is not expensive — it is simply unavailable, at any price.
- This is not yield maintenance. Yield maintenance retires the loan and pays the lender a penalty for the lost interest. Defeasance never retires the loan. Read your note and find out which one you have, because in the same rate environment the two can cost very different amounts.
- You can usually shop the consultant. The servicer will name a preferred firm. In most deals you are free to bid the work out, and on a mid-size loan the spread between quotes can run into five figures.
- The residual belongs to someone. Securities portfolios rarely match the payment schedule to the penny, and the leftover value can be meaningful. The defeasance documents decide whether that residual returns to you or stays with the successor borrower. Ask before you sign, not after.
- An assumption may beat both exits. If your rate is well below today's market, letting the buyer take over the loan can be worth more than any payoff. Assumption fees commonly run around 1% of the balance, far below a premium-priced defeasance.
How much does defeasance cost?
Two separate numbers. First, the cost of the securities portfolio, which can be above or below your loan balance depending on where Treasury yields sit relative to your note rate. Second, hard transaction costs — consultant, accountant, legal, successor borrower and servicer fees — which commonly total in the tens of thousands and do not scale down much on smaller loans.
Can you avoid defeasance on a CMBS loan?
Sometimes. Waiting for the open prepayment window near maturity avoids it entirely. Having the buyer assume the loan avoids it. A few CMBS loans are written with a yield maintenance option instead. What you cannot do is prepay a defeasance-only loan with cash; the documents do not permit it regardless of what you are willing to pay.
Is defeasance cheaper than yield maintenance?
It depends on the rate environment. When Treasury yields have risen above your note rate, defeasance can cost less than par while yield maintenance sits at its 1% floor. When yields have fallen, both get expensive, but defeasance carries fixed transaction costs that yield maintenance does not. Price both against your actual note before deciding which exit you want at origination.
