What it means
The word means to undo or render void, and that is precisely the effect. The borrower does not repay the loan early; instead it buys government securities that will produce exactly the scheduled interest and principal payments, transfers them to a trust, and substitutes them as the collateral in place of the property.
Lenders like the arrangement because it preserves the income stream they priced into the loan, especially when that loan has been packaged into a securitisation where investors expect fixed payments to keep arriving. Borrowers accept it because it is often the only route to selling an asset before the loan matures.
Mechanically, a defeasance involves a securities broker, a defeasance consultant, a successor borrower entity that takes on the loan, and a trustee holding the portfolio. The process usually takes about a month and carries fixed costs that make it uneconomic on very small loans.
Accountants distinguish between legal defeasance, where the borrower is formally released and the debt leaves the balance sheet, and in-substance defeasance, where the assets are ring-fenced but the legal obligation remains. Under most modern standards only a genuine legal release lets you derecognise the liability, so in-substance arrangements often stay on the balance sheet on both sides.
The economics turn on interest rates. When rates have risen since the loan was written, the securities needed to fund the remaining payments cost less than the outstanding balance, and defeasance can be surprisingly cheap; when rates have fallen, the portfolio costs more than the balance and the borrower pays a real premium for the flexibility.
In practice
Real-world examples.
Example
An owner of a distribution warehouse receives an unsolicited offer $4,000,000 above book value, but the property secures a loan with seven years to run. Defeasance costs $520,000 in total, which is easily absorbed by the sale price, so the deal proceeds.
Example
A property fund refinances a shopping centre at a lower rate. Because market yields have fallen since the original loan, the defeasance portfolio costs more than the outstanding balance, and the fund concludes that waiting eighteen months for the open prepayment window is cheaper.
Example
A corporate treasurer defeases a legacy bond issue by placing government securities in trust and obtaining a formal release from bondholders. The auditors confirm this is a legal defeasance, so the liability is removed from the balance sheet and the group's reported leverage falls.
Formula
Calculation
Defeasance cost = present value of the remaining scheduled debt payments, discounted at the yield on the substitute securities, plus transaction fees.
A commercial mortgage has five annual payments of $2,000,000 left. Government securities of matching maturities yield 4%, so the five-year annuity factor is (1 - 1.04^-5) / 0.04 = 4.4518. The portfolio needed therefore costs $2,000,000 x 4.4518 = $8,903,645. Adding $75,000 of broker, trustee, legal and accounting fees brings the total defeasance cost to $8,978,645. If the loan's outstanding balance is $8,600,000, the owner is paying $8,978,645 - $8,600,000 = $378,645 above the balance to be released, and would compare that with the prepayment penalty on the alternative route.Case study
Seen in the real world.
This is an illustrative story about Ridgeway Logistics Properties, a fictional owner of three regional distribution centres. Ridgeway had an $8,600,000 mortgage on its best site with five years to run and a strict lock-out clause preventing early repayment.
When a national carrier offered a price well above valuation for the site, Ridgeway's finance director priced the defeasance. The remaining five annual payments of $2,000,000 would cost $8,903,645 to fund with matching government securities at 4%, and the advisers, trustee and legal work added $75,000, giving a total of $8,978,645.
Because rates had fallen slightly since the loan was written, the exercise cost $378,645 more than the loan balance. Ridgeway went ahead anyway, since the premium on the sale price far exceeded that figure, and the board treated the cost as a straightforward transaction expense rather than a financing failure.
Watch out
Common mistakes.
- Assuming defeasance is the same as paying the loan off early, when the debt actually stays alive and is simply funded by a trust holding government securities.
- Budgeting only for the securities and forgetting the fixed professional fees, which can make defeasance uneconomic on smaller loans regardless of where rates sit.
- Removing the liability from the balance sheet after an in-substance defeasance, when most accounting standards require a genuine legal release before derecognition.
Questions
People also ask.
Is defeasance cheaper than a prepayment penalty?
Sometimes, and it depends entirely on where market yields sit relative to the loan rate, so both routes should be priced before committing.
How long does a defeasance take?
Typically around four to six weeks, because it involves a securities purchase, a successor borrower entity, a trustee and coordinated legal opinions.
Who ends up owning the loan?
The lender or securitisation trust keeps receiving payments, while a successor borrower entity assumes the obligation and holds the pledged securities portfolio.
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