Prepayment Penalty: What is Defeasance?

When it comes to prepayment penalties in commercial real estate loans, defeasance is more complex compared to a standard step-down penalty.

Defeasance refers to the replacement of collateral of a loan by purchasing securities, usually treasury bonds, that will generate cash flows required to replicate the payments of principal and interest on the remaining loan.  In other words, these treasury bonds will provide the lender equivalent returns.

Unlike the other prepayment penalties where there is an actual prepayment of the loan, defeasance entails a substitution of collateral.  Since this process involves the purchase of treasury bonds, defeasance can be advantageous in an environment of rising interest rates because bond prices typically move inversely to interest rates. 

Example:

We have a $10,000,000 CMBS interest-only loan with 5 years remaining.  We need to purchase U.S. Treasuries with maturities matching the loan’s remaining term.  Due to rising interest rates, the cost of purchasing the required treasuries is $9,800,000 which is below the loan balance, reducing the penalty.  On the flip side, if we were in an environment of falling interest rates, the cost of purchasing the required treasuries could be $10,200,000 which is higher than the loan balance, increasing the penalty.

Within this process, the bonds are transferred to a newly created special-purpose entity called the successor borrower, who assumes the debt obligations from the original borrower.  The replacement securities are held in a restricted account of the securities intermediary, which sends the income from the bonds to the loan servicer to meet the debt obligations.  The cash flow used to pay the loan payments are from the treasury bonds that were purchased.

Defeasance is more common in the CMBS (Commercial Mortgage-Backed Securities) market.  This is due to CMBS loans being securitized, meaning that these loans are bundled up and sold to investors. These investors invest in these securities for predictable cash flow and defeasance provides a fixed, risk-free substitute for the loan payments.