Defeasance: Definition, Overview & How It Works
A defeasance is a great tool for commercial lenders and borrowers. It’s one way to protect your investment or security without tying up capital, increasing interest payments, or diluting your ownership via equity financing.
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KEY TAKEAWAYS
- Defeasance helps commercial property buyers to avoid loan prepayment penalties.
- Substitute collateral like treasury bonds de-risks the mortgage.
- Borrowers can use funds raised from the property to pay back their loan through a defeasance.
- Lenders protect their repayment interest in case of early repayments by the borrower.
- Defeasance is ideal when the commercial real estate market has low-interest rates.
- Consult a defeasance expert for legal guidance through the intricate negotiations and transactions.
What is Defeasance?
Defeasance is a collateral substitution option for commercial real estate. Commercial mortgage-backed securities (CMBS) have the chance to substitute their loan collateral. Borrowers enjoy better repayment and tax options with a secure portfolio as collateral.
How Does a Defeasance Work?
A defeasance protects investors from loan prepayment penalties like yield maintenance.
A defeasance sets aside enough funds from treasury bonds to cover the commercial property loan. Commercial properties are typically secured with a U.S. Treasury portfolio. It also comes with a predetermined debt repayment schedule.
In some cases, the property can raise enough cash for the borrower to clear their loan payments earlier than expected. This usually attracts a prepayment penalty. A defeasance allows the borrower to prepay their loan or sell the property without further fines.
Lenders also benefit by receiving consistent loan payments from reputable collateral. This way, defeasance adds value to CMBS properties because lenders are guaranteed to receive their payments in time.
When to Use a Defeasance
Defeasance is ideal if the commercial real estate mortgage fees are reasonable upon exit, including:
- Attorney and accountant fees
- Defeasance of consultant fees, and
- Successor borrower fees
If these charges are less than the loan prepayment penalty, a defeasance clause makes more financial sense. It also works if you can refinance your commercial property mortgage before the subsequent interest rate increase. You can negotiate better repayments within the same interest rate window and save on your mortgage with a defeasance.
For investors, defeasance agreements are a safe bet: U.S. securities are less risky than other types of collateral. Defeasance also favors borrowers because they can refinance or sell the property if the market is right.
Note: The ideal time to seek a defeasance agreement is between 12 and 18 months before your mortgage loan matures. This gives the lender and borrower enough time to process a defeasance agreement. Go for a defeasance there are favorable interest rates and agreeable current loan terms.
What is a Defeasance Penalty?
A defeasance penalty is a prepayment penalty in commercial real estate loans. Once a defeasance agreement takes effect, the property becomes part of the U.S. government securities portfolio. The U.S. government pays the remaining mortgage payments on behalf of the borrower.
The borrower can also refinance or sell the property without facing any prepayment penalties. Defeasing costs are often lower than waiting for the mortgage to mature. It can potentially save borrowers hundreds of thousands of dollars if they exit their mortgage early.
Example of Defeasance
Here is how defeasance works in a practical setting: A commercial property buyer has a chance to pay off their mortgage before schedule. But they face substantial prepayment penalties because their lender expects a given return for their investment over time. Making a payment earlier means that the lender loses potential returns in the remaining time.
When government-backed security becomes the loan’s collateral, the lender rests easily—a high-quality bond covers the property. Buyers can then take full advantage to recoup their investment if it makes financial sense to exit their mortgage early. A defeasance agreement is a win-win process for all parties.
Summary
Defeasance is a strategic investment solution for commercial real estate investors. It works best in a low-interest rate market, but investors can undoubtedly strike a favorable deal at any time. Defeasance protects buyers from unnecessary penalties and saves lenders from prepayment losses. Keep in mind that this article is purely for your information, not legal advice. Find a reputable defeasance consultant to guide your investment planning today.
Frequently Asked Questions about Defeasance
In defeasance, the original loan terms remain the same, but the collateral gets replaced. Yield maintenance keeps your prepayment terms the same. This means that you’ll still have to pay your outstanding balances and face penalties. Yield maintenance may cost less for your loan because there are no defeasance consultancy fees. But a defeasance yields higher returns with the right financial consultant.
The borrower caters for all defeasance costs, but they are tax-deductible. You can claim it at the end of every financial year.
Use an online defeasance penalty calculator for a quick estimate. Simply enter your original loan amount and interest rate, plus the payment dates and amortization. You may also include details like the loan servicer and current and forecasted interest rates.
A defeasance transaction is where a lender and borrower agree on new collateral for their commercial mortgage terms. A defeasance clause triggers when a borrower satisfies the mortgage repayment conditions. The defeasance process typically takes about 40 days to complete the transaction. Some services may charge expediting fees to process within 30 days.
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