What it means
Commercial property lenders, especially those that package loans into bonds, depend on a predictable stream of payments. They therefore resist early repayment, which would leave them holding cash they must reinvest at lower rates.
A defeasance clause offers a compromise: the borrower is free to sell or refinance the building, and the lender still receives every payment it was promised. The mechanics are straightforward in concept.
The borrower buys government securities whose scheduled interest and principal payments match the loan's remaining payments, and those securities replace the building as the lender's collateral. Once that is done, the lender releases its claim on the property.
The real cost to the borrower is the price of the securities. When market interest rates are below the loan's rate, the securities needed to replicate the payments cost more than the outstanding loan balance, so defeasance becomes expensive.
When market rates are higher than the loan rate, the securities can cost less than the balance, which makes the clause attractive. Defeasance clauses are also compared with prepayment penalties and yield maintenance clauses.
A fixed percentage penalty is easy to predict, while defeasance cost moves with the bond market and can only be priced close to the date of the transaction. Borrowers should therefore ask for an indicative quote well before they commit to selling an asset.
The phrase has an older legal meaning as well, referring to a condition in a deed or contract that, once met, makes the agreement void. In modern finance, though, almost every reference is to the loan-collateral swap described here.
In practice
Real-world examples.
Example
A property company wants to sell an office building that has seven years left on a commercial mortgage. The loan prohibits early repayment, but the defeasance clause lets the company buy matching government securities and hand the building to the buyer free of the loan.
Example
A hotel owner finds that interest rates have risen since the loan was signed. A defeasance quote comes in below the loan balance, so the owner uses the clause to exit early and then refinances on better terms elsewhere.
Example
A retail landlord compares two loan offers. One has a flat 3% prepayment penalty and the other has a defeasance clause, and the landlord models both under rising and falling rate scenarios before choosing.
Formula
Calculation
Cost of securities = sum of (each remaining loan payment / (1 + yield on the securities) ^ years until payment)
Total cost to borrower = cost of securities + legal and advisory fees
A borrower owes a single remaining payment of $5,408,000 in exactly one year, made up of the loan balance and interest. Government securities currently yield 4%, so the cost of securities that pay $5,408,000 in one year is $5,408,000 / 1.04 = $5,200,000. Suppose fees are $60,000, so the total cost of defeasance is $5,200,000 + $60,000 = $5,260,000. If the outstanding loan balance is $5,000,000, the borrower pays $260,000 more than the face balance to be released from the loan.Case study
Seen in the real world.
Marlow Park Holdings is an illustrative, fictional company that owns a small shopping centre financed with a ten-year fixed-rate loan. In year six, a buyer offered a price well above the building's carrying value, but the loan could not simply be repaid.
The finance manager requested a defeasance quote and found that falling market rates had pushed up the cost of the matching securities. The premium over the loan balance was about 6%, which reduced but did not eliminate the profit from the sale.
Marlow Park, which is a made-up example, still proceeded because the sale price covered the extra cost with room to spare. The lesson was that defeasance cost should be built into any deal timetable from the start, rather than discovered at the closing table.
Watch out
Common mistakes.
- Assuming a defeasance clause means the loan can be repaid at face value at any time, when the borrower must actually buy securities that can cost more than the balance.
- Waiting until just before a sale to ask for a quote, when the cost moves with the bond market and with the time left on the loan.
- Forgetting the legal, accounting and servicer fees, which can be significant on top of the price of the securities.
Questions
People also ask.
Does defeasance remove the borrower's obligation?
In most structures the property is released and a special purpose entity (a separate company created for the task) takes over the securities and the loan, but the borrower should confirm exactly what liability remains.
Why do lenders prefer defeasance to early repayment?
Because the lender keeps receiving the exact payments it expected, which protects investors in any bonds backed by the loan.
Is defeasance cheaper when rates rise or fall?
It is generally cheaper when market rates rise above the loan rate and more expensive when they fall below it.
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