What it means
The process starts with a request to the loan servicer, which is the firm that administers the loan on behalf of the lender or bondholders. The servicer confirms that the clause can be used, states any notice period, and provides the schedule of remaining payments.
Borrowers typically need to give notice of 30 days or more, so planning ahead is essential. Next, the borrower hires a defeasance consultant or uses a specialist bank to price and buy the securities.
The securities are normally government-issued, because they are considered close to free of default risk. They are chosen so that their interest and principal payments arrive on or before each payment date on the loan.
The securities are then placed in a separate legal vehicle, often called a successor borrower, that takes over the loan obligation. Lawyers prepare the documents, accountants confirm the numbers, and an independent party often certifies that the cash flows match.
Once everything is in place, the lender releases the property and the original borrower is free to sell or refinance it. The cost drivers are the price of the securities and the professional fees.
If the securities cost more than the outstanding balance, the difference is a real economic cost, though the loan itself has been settled. Fees vary by deal size and complexity but are usually small compared with the securities cost, and they should be agreed in writing before work starts.
Timing and documentation are the usual sources of delay. A mismatch of even a few days between payment dates can force a purchase of extra securities, so the cash flow schedule needs careful checking before the order is placed.
Finance teams should also agree who signs off each stage, since a missing signature at the servicer can hold up the release of the property.
In practice
Real-world examples.
Example
A developer selling a warehouse gives the servicer 45 days' notice, then works with a defeasance consultant to price the securities. The sale closes on schedule because the loan is released on the day of completion, and the buyer receives the building free of any charge.
Example
A hospital group wants to refinance a mortgage on one clinic to fund an expansion. Its treasurer builds a timeline showing the notice period, pricing date, document signing and release, and shares it with the buyer's lawyers.
Example
A family-owned hotel business discovers during due diligence that its loan can only be exited by defeasance. It engages a specialist adviser early, and the quote helps it negotiate a slightly higher sale price to cover the premium. The owners also learn that the quote will move with bond yields, so they ask for a refreshed figure a week before closing.
Formula
Calculation
Total cash needed = cost of securities + fees
Premium over loan balance = total cash needed - outstanding loan balance
A borrower has a $3,000,000 loan balance. The matching government securities cost $3,120,000 and fees come to $30,000. Total cash needed = $3,120,000 + $30,000 = $3,150,000. Premium over balance = $3,150,000 - $3,000,000 = $150,000, which is 5% of the balance ($150,000 / $3,000,000 = 0.05).Case study
Seen in the real world.
Cobalt Ridge Properties is a fictional company used here as an illustrative example. It agreed to sell an apartment block in 60 days, but its loan could only be cleared by defeasance.
The finance team made the mistake of asking for the securities price only two weeks before closing. The servicer needed 30 days' notice, so the sale had to be pushed back by three weeks, and the buyer asked for a small price reduction in return.
On the next property sale, Cobalt Ridge, again an illustrative company, started the process on the day the offer was accepted. The deal closed on time and the treasurer kept a standard checklist with each step and responsible party. The checklist also recorded the expected premium over the loan balance, so the board could see the full cost of the exit before approving the sale.
Watch out
Common mistakes.
- Starting the process after the sale contract is signed, when the notice period alone can exceed the closing timetable.
- Assuming any government security will do, when the payments must match the loan's schedule closely enough to cover every instalment.
- Budgeting for the securities only and ignoring legal, servicer and consultant fees.
Questions
People also ask.
Who carries out the defeasance?
Usually a specialist consultant or bank arranges the securities, a lawyer prepares the documents, and the servicer approves and releases the property.
How long does it take?
It often takes several weeks, depending on notice periods and the complexity of the loan documents, so it should be planned into the sale timetable from the start.
What happens to the securities afterwards?
They stay in the successor borrower, and their payments are used to make the remaining loan payments to the lender until the loan reaches its final maturity date.
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