What Is Defeasance In Real Estate? (TOP 5 Tips)

Defeasance, as its name suggests, is a method for reducing the fees required when a borrower decides to prepay a fixed-rate commercial real estate loan. Instead of paying cash to the lender, the defeasance option allows the borrower to exchange another cash-flowing asset for the original collateral on the loan.


What is a defeasance clause in real estate?

A defeasance clause is a term within a mortgage contract that states the property’s title (a fancy word for “ownership”) will be transferred to the borrower (mortgagor) when they satisfy payment conditions from the lender (mortgagee).

How does a defeasance work?

How the Defeasance Process Works. With defeasance, the debt obligation does not go away, but the defeasance process releases the mortgaged property’s title to the borrower. That allows the borrower to refinance or sell the property before the loan has been fully paid off.

What is a defeasance of a loan?

Defeasance is a provision in a contract that voids a bond or loan on a balance sheet when the borrower sets aside cash or bonds sufficient enough to service the debt.

What is the difference between defeasance and yield maintenance?

Yield maintenance is the actual prepayment of the loan, while defeasance entails a substitution of collateral and a legal assumption of the loan by the successor borrower. A yield maintenance prepayment has two components: the unpaid principal balance of the loan and a prepayment penalty.

What is Reg Z in real estate?

Regulation Z prohibits certain practices relating to payments made to compensate mortgage brokers and other loan originators. The goal of the amendments is to protect consumers in the mortgage market from unfair practices involving compensation paid to loan originators.

What Lien has the highest priority?

A first lien has a higher priority than other liens and gets first crack at the sale proceeds. If any sale proceeds are left after the first lien is paid in full, the excess proceeds go to the second lien—like a second-mortgage lender or judgment creditor—until that lien is paid off, and so on.

What is the collateral in a blanket mortgage?

A blanket mortgage is a single mortgage that covers two or more pieces of real estate. The real estate is held together as collateral, but the individual properties may be sold without retiring the entire mortgage. Blanket mortgages are commonly used by developers, real estate investors, and flippers.

What is defeasance penalty?

Defeasance as a Prepayment Penalty for Multifamily and Commercial Real Estate Loans. Defeasance refers to the replacement of the collateral of a loan with securities (generally fixed-rate government bonds) that will offer a lender an equivalent return.

When would the defeasance clause in a mortgage take effect?

This clause specifies that the mortgage borrower will be given the property title once all the mortgage payments are over. Defeasance works as soon as a mortgage is fully paid. It then helps legally transfer the title ownership from the lender to the borrower.

Do all CMBS loans have defeasance?

While most CMBS lenders require borrowers to use U.S. Treasury bills to conduct defeasance, others may allow them to use agency bonds, such as Freddie Mac or Fannie Mae bonds, which are typically less expensive.

What is standard defeasance?

Defeasance, as its name suggests, is a method for reducing the fees required when a borrower decides to prepay a fixed-rate commercial real estate loan. Instead of paying cash to the lender, the defeasance option allows the borrower to exchange another cash-flowing asset for the original collateral on the loan.

What is a due on sale clause in real estate?

An alienation clause, also known as a due-on-sale clause, is a real estate agreement that requires a borrower to pay the remainder of their mortgage loan off immediately during the sale or transfer of a property title and before a new buyer can take ownership.

What Is Loan Defeasance?

Real estate has traditionally been the preferred investment for people seeking to accumulate long-term wealth for their families and future generations. By subscribing to our complete real estate investment guide, you will receive assistance in navigating this asset class. If you have a fixed-rate commercial real estate loan, there is a good chance that you will be liable to a steep prepayment penalty. However, what most real estate investors are unaware of is that they may be able to employ loan defeasance to avoid having to pay those costs in the first place.

What is loan defeasance?

Loan defeasance is, at its heart, a method for commercial mortgage borrowers to avoid paying a prepayment penalty if they want to pay off their loan early. The defeasance procedure allows the borrower to replace the loan’s initial collateral (which is most usually the mortgaged property) with another asset, so increasing the value of the loan. The new collateral is often comprised of government assets, such as Treasury bonds, which are issued by the government. A noteworthy requirement of the bonds is that they must generate the same level of income as the original loan payment, allowing the mortgage lender to maintain the same level of cash flow on its balance sheet while allowing the property owner to retain complete ownership of the asset.

Typically, this type of financing scenario arises when the property’s owner wishes to refinance or sell the property.

At the very least, the loan must be a commercial real estate loan in order for defeasance to be considered as an alternative.

What are the advantages and disadvantages of loan defeasance?

The most significant benefit of loan defeasance to the borrower should be very obvious to everyone. A defeasance transaction gives the borrower the flexibility to sell or refinance a property (for leverage or for any other purpose) before they have completely paid off the initial loan balance. Furthermore, it enables them to take advantage of prepayment without being subjected to a steep prepayment penalty. The benefits to the loan servicer are likewise very clear to understand. By using defeasance, it is able to maintain the same amount of cash flow on its balance sheet while eliminating some of the risks associated with its investment.

Because government securities, such as Treasury bonds, are known for being low-risk, the servicer stands to gain financially from this arrangement as well.


The cost of loan defeasance can be prohibitively expensive for real estate investors, which is one of the disadvantages of the practice. Because interest rate swings have a direct influence on Treasury bond prices, purchasing bonds might become prohibitively expensive for the original borrower if interest rates are high. Although it’s worth noting that, in some cases, agency bonds, such as those offered by Fannie Mae and Freddie Mac, will be acceptable in lieu of true government securities – and that those options are frequently more affordable – it’s important to remember that not all government securities are created equal.

For starters, loan defeasance lowers the likelihood of reinvestment risk occurring.

What should investors know before deciding on loan defeasance?

In the event that you are considering refinancing your mortgage loan or selling your investment property and would like to investigate the possibility of defeasance, the first step is to carefully review your loan documentation. An anti-defeasance clause must be included in the contract in order for this to be considered an alternative to a prepayment penalty. If this is not the case, you will need to look into other methods for paying off your CMBS loan. Additionally, before deciding on defeasance for your business loan, it is always a good idea to speak with a defeasance specialist to ensure that your interests are protected.

The Millionacres bottom line

Even though defeasance may be a more inexpensive alternative for some commercial real estate owners who are faced with the potential of a significant prepayment penalty, it is not the best option for everyone in every situation. Don’t hesitate to seek out to specialists who can answer your questions regarding the procedure if you’re thinking about taking this path for your business mortgage. In the meanwhile, let this information assist you in beginning to consider if loan defeasance is the best course of action for your situation.

Demystifying Defeasance

Defeasance deals continue to close despite the fact that the credit markets are frozen and conduit lenders are not lending. According to the Federal Reserve’s Flow of Funds report, more over 36 percent of all existing commercial and multifamily loans were securitized at the end of 2007, accounting for $913 billion of the $3.3 trillion in total outstanding loans. If a borrower is trying to acquire, sell, or refinance a property, there is a strong chance that the property is subject to defeasance clauses.

Generally, a conventional defeasance results in the discharge of the mortgage lien that was previously in place.

Alternatively, if the encumbered property is situated in one of these states, borrowers may choose to sign a fresh note defeasance in place of a normal defeasance in order to enjoy some savings on the recording tax.

New note defeasances, on the other hand, have certain structural peculiarities and involve a greater number of participants throughout the procedure.

Understanding these distinctions can assist borrowers and their attorneys in better navigating the defeasance process, resulting in money savings in the long run.

Understanding Defeasance

Conduit mortgage loans are aggregated (or securitized) into real estate mortgage investment conduit trusts, which invest in real estate mortgage investment conduit trusts. The certificates issued by these REMIC trusts, also known as commercial mortgage-backed securities, are subsequently sold to investors who anticipate receiving a consistent cash flow from their investment. If a borrower chooses to pay off a loan early, this cash flow is interrupted. A defeasance ensures that loan payments will continue to be made even after the property has been freed from the mortgage.

  • Defeasance is both an economic (maintaining cash flows to CMBS investors) and a legal operation (substitution of collateral and substitution of the borrower), and it includes a large number of participants, each with a distinct role and set of interests.
  • Defeasance provisions provide borrowers with the flexibility to remove their obligations from the underlying real estate in order to sell or refinance the property.
  • assets, primarily Treasury liabilities, that is structured to meet the debt service schedule of the loan through the maturity date, rather than the existing collateral.
  • In this transaction, the loan stays in place, and the defeasance portfolio provides the CMBS bondholders with the identical future cash flows they would have gotten if the loan had not been defeased in the first place.

New Note Defeasance

Defeasance transactions do not take place in the same way everywhere. Standard defeasance events for properties in certain jurisdictions, including Washington, D.C., Maryland, Minnesota, New York, Florida, and Virginia, result in the imposition of a significant mortgage recording tax on buyers, or in the case of refinances, on the original borrowers, when the property is sold. To address the exorbitant tax costs associated with standard defeasances, the New York Department of Taxation and Finance published Advisory Opinion No.

This was the first and only state to formally address these concerns with the publication of the Advisory Opinion.

Defeasance in the “New York style” or “new note” manner came to be known as the “new note” defeasance.

Most of the defeasance procedure is controlled by the requirements of the original loan contracts as well as the legal rules that underpin the REMIC structure, which are outlined below.

Although loan servicers are not required to accommodate requests to structure debt forgiveness transactions in this manner in order to help borrowers reduce the mortgage recording tax, they are generally willing to do so when the loan documents do not specifically state that such a transaction is permitted.

Besides the federal recording tax, a state recording tax is paid on new debt.

In New York Municipal, a borrower who refinances a $30 million loan with $40 million in debt would be required to pay $1,120,000 in taxes ($40 million multiplied by 2.8 percent), based on the city tax rate of 2.8 percent.

The original borrower may also choose to assign his or her current loan to a refinancing lender in place of paying off the old mortgage, allowing him or her to keep all of the mortgage recording tax previously paid on the existing debt.

Instead, the borrower is only liable for a recording tax on the amount by which the new loan exceeds the original principal balance of the previous loan, not on the whole amount of the loan. Any possibility of releasing the old mortgage has been gone.

Steps in the Process

A defeasance note is executed in favor of the new lender in the amount of the original note’s current outstanding balance, with terms that are identical to the original note. This is the starting point of the procedure, which is initiated by the original borrower. In order to secure the defeasance note, the borrower enters into a pledge arrangement with the new lender, pledging the defeasance collateral as security. In exchange for this, the new lender provides the trust the defeasance note and the pledged defeasance collateral, and the trust receives the original note and mortgage from the trust at closure.

You might be interested:  What Is Abatement In Real Estate? (Solution found)

In this case, the original borrower transfers the defeasance note and the pledge agreement to the successor borrower, who in turn bears responsibility for the defeasance note’s obligations.

The original note and mortgage are now in the possession of the new lender.

The amount of the new debt must be considered in conjunction with the percentage of mortgage recording tax to determine whether the new debt is large enough to justify the additional legal fees that will be incurred by both the servicer’s counsel and the new lender’s counsel when deciding whether to proceed with a new note defeasance.

This is because they are both parties to the defeasance instruments.

However, the potential savings that a borrower may gain make the extra work worthwhile in terms of both time and energy.

Step 2: In exchange for the defeasance pledge agreement, the trust transfers ownership of the original mortgage to the new lender.

What is Defeasance and How Does it Work? — Multifamily.loans

When it comes to multifamily and commercial finance, there are a number of different methods that a borrower might possibly refund their lender for prepaying their loan. Prepayment penalties that are commonly encountered include yield maintenance, step-downs, and soft-step downs. However, defeasance, another prominent sort of prepayment penalty, is also frequently available, notably for CMBS loans as well as for some Fannie Mae ® and Freddie Mac ®multifamily loans, as well as for other types of loans.

Borrowers will often be required to acquire United States Treasury bonds in order to carry out defeasance, while other forms of government-backed assets may be utilized in some situations as well.

As a consequence, the lender will not suffer any revenue loss as a result of the borrower’s early repayment of their loan. Generally, borrowers want to prepay their loans because they intend to sell their home before the loan’s term is up, rather than because they are in default.

Defeasance Generally Requires Expert Consultants

Much in the same way that a commercial or multifamily real estate investor involved in litigation would generally prefer to hire a lawyer rather than represent themselves in court, most borrowers who wish to defease their loan will generally prefer to hire a defeasance consultant who will handle the entire process on their behalf. While the notion of defeasance may appear straightforward, the practice of defeasance may be difficult to master. The precise amount of bonds must be acquired, secured in the proper manner (usually through a custodial account), and documented and lodged as real estate for tax purposes in the appropriate place.

A borrower (or their original accountant) may not be familiar with the sort of paperwork and documentation necessary to claim a defeasance deduction, for example, even though the defeasance expense is deductible.

When is Defeasance a Good Idea?

In some cases, defeasance may be the most advantageous option for a commercial or multifamily real estate borrower, depending on the current interest rate environment and other variables. Borrowers who defeasance their mortgages may potentially profit from the process if market interest rates rise beyond the rate of the mortgage. The specific defeasance terms permitted by a lender will also influence whether or not defeasance is a wise decision for a borrower. Defeasance of a mortgage using Freddie Mac®, Fannie Mae®, or Ginnie Mae bonds is often substantially less expensive for a borrower than defeasance of a mortgage using U.S.

As you can see, whether or not defeasance is the greatest option for a particular borrower is dependent on their specific circumstances; but, defeasance is virtually generally a good idea for lenders in most cases.

The United States Treasury, Fannie Mae, and Freddie Mac would have to experience a genuine economic catastrophe before they would cease paying the interest on their debts.

Deciding on Defeasance vs. Yield Maintenance

The choice between yield maintenance and defeasance as loan prepayment penalties will be presented to a borrower in a number of instances. This is frequently the case when it comes to commercial mortgage-backed securities loans. A lender’s defeasance agreement specifies the specific provisions that must be followed when deciding between the two possibilities listed above. When bond interest rates are compounded monthly and payments are computed until the maturity date, defeasance is typically the best option (and when the overall yield maintenance prepayment penalty is greater).

In contrast, if bond interest rates are compounded annually and payments are computed to the loan’s prepayment date, the yield on the bond is often maintained at its ideal level (and when the overall yield maintenance prepayment penalty is smaller).

What Is Defeasance? — Commercial Real Estate Loans

Debt forgiveness is a method that allows for the repayment of a commercial real estate debt on a property in order to assist the sale or refinance of the property in question. A large number of securitized mortgages are bundled together to form investment instruments known as CMBS, or Commercial Mortgage Backed Securities (CMBS). Prepayment of these goods is often restricted since the stability of these products is dependent on the assured return of the investment from the interest paid throughout the initial duration of the loan.

Defeasance is the process of replacing loan proceeds with government-backed assets, such as treasury bonds, that provide the same rate of return as the loan proceeds.

As a consequence, the borrower will be able to pay off the commercial mortgage loan early and sell the property without a lien being passed to the buyer of the property.

Both Borrowers and Lenders Benefit from Defeasance

Debt forgiveness may be extremely helpful to borrowers in general, since it entails the substitution of a risky asset (a commercial real estate loan) with a considerably safer asset (a home equity line of credit) (typically U.S. Treasury bonds). Additionally, defeasance can be beneficial to borrowers since it allows them to exit a loan early, allowing them to use their cash for other investments that may offer a greater income than their initial commercial property.

Borrowers Typically Require Experts to Assist With Defeasance

Because the defeasance procedure is difficult and time-consuming, most debtors who are considering defeasance will typically engage a team of defeasance experts to assist them in completing defeasance with the least amount of bother as is reasonably feasible. This frequently comprises bond purchasers, attorneys, and, in some cases, tax specialists (fortunately for borrowers, defeasance is tax deductible.) To their surprise, some defeasance advisors do not always advise debt forgiveness; in certain cases, depending on the circumstances and current Treasury rates, it may be preferable to avoid prepayment of the loan entirely.

For example, when a lender enables a borrower to use agency bonds, defeasance is preferable; when a lender requires a borrower to use Treasury bonds, defeasance is less preferable.

Yield Maintenance vs. Defeasance

As a result of the complexity and time commitment involved in the defeasance procedure, most debtors who are considering defeasance will employ a team of defeasance advisors to assist them in completing the process as smoothly as possible. This frequently comprises bond purchasers, attorneys, and, in certain cases, tax specialists, among other professionals (fortunately for borrowers, defeasance is tax deductible.) To their surprise, some defeasance advisers do not always advise debt forgiveness; in certain cases, depending on the circumstances and current Treasury rates, it may be preferable to forgo prepaying the loan entirely.

For example, when a lender enables a borrower to utilize agency bonds, defeasance is more advantageous; yet, when a lender requires a borrower to use Treasury bonds, defeasance is less advantageous.


  • It is similar to a loan prepayment penalty in that it requires the substitution of collateral
  • However, it is more severe. If a loan is included in a commercial mortgage-backed security, the holder of the security anticipates a particular stream of cash flows to be generated by the loan over the long term. It is possible that the loan will be paid off early, causing the stream to be interrupted. A “penalty” in the form of a basket of securities, created to replace the cash flow stream lost as a result of the paid-off loan, must be paid by the borrower in order to restore that stream of cash flows. Defeasance provisions increase the risk profile of an investment transaction since they might restrict a borrower’s ability to explore a sale or refinancing of the asset. As a side effect, it might result in high and unanticipated transaction expenses. When it comes to defeasance provisions in loan agreements, it is not required for an investor to be familiar with the exact legal terminology surrounding them. Being aware that the provision exists and that it has the potential to enhance the risk in a transaction through less flexibility and increased transactions costs is critical.

It is similar to a loan prepayment penalty in that it requires the exchange of collateral; however, it is more serious. It is expected that the holders of commercial mortgage-backed securities (CMBS) would receive a specific stream of cash flows in the future if the loan is included in the CMBS. A disruption occurs if the loan is repaid in full before its scheduled maturity date. A “penalty” in the form of a basket of securities, built to replace the cash flow stream lost as a result of the loan being paid off, must be paid by the borrower in order to restore that stream of cash flows.

The outcome might be considerable and unanticipated transaction fees, as well.

Being aware that the provision exists and that it has the potential to enhance the risk in a transaction through limited flexibility and increased transactions costs is critical information.

Defeasance: Defined

A lender may pool a number of commercial real estate loans together and sell them as a “securitized” package once a loan has been issued. Essentially, this implies that they manufacture and sell investment instruments that are backed by the cash flow generated by the loan payments and interest payments. These are referred to as “commercial mortgage-backed securities” or “CMBS” for short, and they are a popular asset among many institutional investors because of their low risk and high return.

The repayment of one of the loans that underpin the securities, on the other hand, will produce a disturbance in the cash flow, resulting in the investor earning a return that is different from what was anticipated.

This penalty, referred to as “defeasance,” ensures that the loan’s installments will be made even after the loan has been paid off and the lender has relinquished their lien on the underlying real estate.

Treasury Bonds or other government securities) that generates enough income to cover the needed loan payments.

When Does Defeasance Make Sense?

The question of whether or not it is worthwhile to pay the defeasance penalty boils down to a straightforward cost-benefit analysis. If the cost of the penalty is less than the possible benefit to be received, it may be worthwhile to take the risk. Consider the following scenario: a borrower is considering refinancing the loan on his or her business property. As a result, the borrower will be required to acquire $50,000 in securities in order to replace the loan payments that were originally made.

The refinancing, on the other hand, will result in a monthly savings of $1,500. This means that within 33 months, the borrower will be able to recoup the $50,000 in fees and interest. The payment of the defeasance penalty may be justified in such a situation.

Sample Defeasance Language

If a loan arrangement has a provision for defeasance, the specific contractual language might differ significantly. However, the wording in the following section is a good representation of what may be found in a loan contract: According to the Indenture, “subject to certain conditions set forth therein,” the Company may terminate some or all of its obligations under the Securities and the Indenture at any time if it deposits with the Trustee money or U.S. Government Obligations sufficient to cover the payment of principal and interest on the Securities until redemption or maturity, as the case may be.” During a commercial real estate transaction, it is critical for investors to be aware of the possibility of defeasance and to be familiar with the exact wording used to analyze the risk involved in the transaction.

How Does the Defeasance Process Work?

While the defeasance terminology might differ depending on the lender, the method is generally the same regardless of the lender. Generally speaking, there are three steps. First, the original borrower signs a defeasance note in the amount of the current outstanding debt, which is then returned to the lender. Its terms, such as the maturity date, debt service requirements and payback, are identical to those of the original loan agreement. Because of the deficiency note, the borrower guarantees a portfolio of securities to the new lender as security for the debt.

Following that, the original borrower transfers ownership of the defeasance note and securities pledge agreement to a successor borrower, who then assumes responsibility for the debt obligations under the defeasance note and securities pledge agreement.

The hiring of a defeasance consultant or lawyer to assist with the complexity is an option.

Why Defeasance Raises the Risk Profile of an Investment Transaction

Even while the inclusion of a defeasance provision in the loan terms is undesirable, it is not always the case. However, it is something that investors should be aware of since it increases the risk profile of the transaction in two ways: by increasing the transaction’s flexibility and by increasing the transaction’s transaction costs. First and foremost, the presence of defeasance restricts the transaction’s ability to be flexible. To take advantage of decreased interest rates, a property owner, for example, may seek to refinance his or her loan in order to reduce monthly payments.

Secondly, depending on where the property is located, the occurrence of defeasance may result in the imposition of hefty taxes on the property owner.

Defeasance events for real estate located in states such as Maryland, Minnesota, or Florida, for example, can result in large mortgage recording taxes being imposed on the purchasers (in a purchase) or on the original borrower (in a refinance) (in a refinance).

The Bottom Line

Individual investors who deposit their money with a commercial real estate transaction sponsor do not need to be familiar with the technical legal jargon associated with defeasance in order to make a profit. The key is to determine whether or not this provision is included in the loan documentation, as well as how the sponsor intends to handle the costs connected with it in the event of a sale or refinance. It’s a fine question to ask, and it’s even better to be aware of the knowledge that comes with it.

Interested In Learning More?

First National Realty Partners is one of the nation’s premier private equity commercial real estate investment businesses. The company was founded in 1989 and is headquartered in Dallas, Texas. We use our decades of experience, as well as our available cash, to identify world-class, multi-tenanted assets that are undervalued relative to their true worth. Ultimately, we hope to provide better long-term, risk-adjusted returns for our investors while also producing valuable economic assets for the communities in which we invest, as described above.

You might be interested:  How To Become A Real Estate Appraiser In Florida? (Solution)

Defeasance FAQs

  • What is the process of defeasance? What exactly is Chatham’s function in a defeasance scenario? What is residual value, and where does it originate from, and how does it work? What is the total timing for the defeasance? What is the accuracy of my estimate
  • What is the relationship between defeasance and yield maintenance? What method is used to acquire defeasance bonds
  • Is it necessary to acquire defeasance bonds in order to make all of my remaining loan payments until maturity, or only the installments up to the early open prepayment date
  • When there is defeasance, who are the additional parties that are involved, and what are their responsibilities? Who is in charge of determining the transaction costs for these parties
  • Specifically, what can I do to make debt extinguishment easier and less expensive in the future

How does defeasance work?

Debt forgiveness is the procedure through which a borrower is relieved of the financial responsibilities associated with the debt. The borrower purchases a portfolio of government bonds as replacement collateral in order to secure the debt and provide the cash flows necessary to make the periodic payments of principal and interest on the loan that remain outstanding. The defeasance bonds are transferred to a newly constituted special-purpose business known as a successor borrower, which takes the debt obligations of the original borrower and transfers the debt liabilities to the successor borrower.

  • In this case, an independent accountant evaluates the transaction and verifies that the bond portfolio is sufficient to meet the debt obligations.
  • When the borrower submits a notice of intent and defeasance deposit to the loan servicer, the procedure is said to have commenced.
  • The borrower will have the opportunity to review and execute the documents.
  • It takes two to three days in escrow, and it takes happen at the same time as the underlying refinancing or sale of the property.
  • The borrower deposits monies into escrow on the day before the final closing date, often utilizing the profits from the refinancing or sale of the property in question.

Upon the final closing day, the bonds are given to the securities intermediary bank, and the money that were held in escrow are disbursed to complete the purchase of the bonds.

What is Chatham’s role in a defeasance?

Chatham serves as the borrower’s defeasance consultant in his capacity as an impartial, professional advisor. Chatham offers cost estimates, advises the borrower on how to traverse the defeasance process, engages counterparties, and ensures that the defeasance is performed in a timely and cost-effective way. Chatham is headquartered in New York. If permitted by the loan terms, Chatham can also acquire the defeasance bonds and form the successor borrower organization that will accept responsibility for the loan at the time of closure on the transaction.

The purpose of Chatham as a defeasance consultant is to make the defeasance procedure as simple as possible so that our customers may concentrate on the underlying real estate transaction.

What is residual value in defeasance and where does it come from?

The residual value of a loan is the cash in the defeasance account that has not been committed to make loan payments in the past. Both float value and prepayment value contribute to residual value, which is calculated as the sum of these two components. As the loan matures, the accrual of float value occurs gradually throughout the course of the loan’s remaining life. There are minor time misalignments between the incoming cash revenues from the bonds and the outgoing cash payments on the loan that cause this problem.

  • When the loan is repaid in full at the end of the term, the float value is transferred to the succeeding borrower.
  • The successor borrower will pay down the principal balance of the defeased loan on the early open prepayment date, which is the day after the defeased loan was paid off.
  • The prepayment value is the difference between the sale price of the released bonds and the cost of repaying the defeased loan, and it is calculated as follows: Chatham was the first corporation to make residual value available to the public.
  • When it comes to receiving this value, Chatham offers two options: on a present-value basis at the time of the defeasance transaction’s closing date, or on an actual-value basis at the time of loan maturity.

As part of Chatham’s ongoing commitment to openness, we always publish the overall amount of residual value received, as well as the specific conditions of our sharing arrangements, to our investors.

What is the overall defeasance timeline?

We recommend that you allow at least 40 days for the defeasance procedure to be completed. A typical loan servicer would waive any specified notice time as well as any need that the defeasance close on or before a loan payment date in the majority of circumstances. Loan servicers, on the other hand, may impose an expediting fee if the loan is closed in fewer than 30 days from the date of the notification and deposit. As soon as the defeasance process is initiated, the closing date is flexible and can be amended at any time up until the defeasance bonds are procured.

How accurate is my estimate and how often does it change?

The current market price of the defeasance bonds is used to calculate the securities cost reflected on your estimate. Bond values fluctuate rapidly, resulting in estimates that are merely a few minutes apart showing very different costs. Costs will very certainly fluctuate between the time of the estimate and the time of the defeasance’s final closure date. A measure of sensitivity, denoted by the letter DV01, indicates how much the cost of securities will vary for every basis point change in interest rates.

At the conclusion of the transaction, Chatham aims to buy the lowest-cost bond portfolio possible through a competitive auction among different banks (when allowed by the loan documents).

These fees are difficult to predict since they are dependent on charge schedules and historical experience.

How does defeasance compare with yield maintenance?

Both yield maintenance and defeasance allow borrowers to release themselves from the need to repay the loan. While they are both legal and economically valid procedures, they are fundamentally distinct from one another. Yield maintenance refers to the real payback of the loan, whereas defeasance refers to the substitution of collateral as well as the legal takeover of the debt by the successor borrower in the loan transaction. A prepayment for yield maintenance includes two components: the outstanding principle balance of the loan and a prepayment penalty, which is applied to the unpaid principal balance.

The prepayment penalty is commonly calculated using the present value of the remaining loan installments.

The cost of defeasance, on the other hand, is defined by the price of a portfolio of bonds that is adequate to cover the outstanding loan installments, plus processing costs to a number of third-party financial institutions.

How are the defeasance bonds purchased?

Both yield maintenance and defeasance allow borrowers to remove themselves from the obligation of the underlying real property asset. Nonetheless, the two procedures are fundamentally different from a legal and economic standpoint. Prepayment of the debt through yield maintenance is different from defeasance, which involves the substitution of collateral as well as the legal absorption of the loan by a subsequent borrower. When making a prepayment to maintain yield, there are two components to consider: the outstanding principle balance of the loan and the penalty for making the prepayment.

Small processing fees to loan servicers are the sole fees associated with a transaction involving a loan.

The cost of defeasance, on the other hand, is defined by the price of a portfolio of bonds that is adequate to cover the outstanding loan installments, plus transaction costs to a number of third-party creditors.

Do I need to purchase defeasance bonds to make all my remaining loan payments through maturity, or just the payments up to the early open prepayment date?

There are several loans that have an early open prepayment window, which permits the loan to be returned in full before the loan’s maturity date. Defeasance bonds must be sufficient to cover all outstanding loan payments through the loan’s maturity date, unless the loan terms specify that they only need to cover loan payments up to the early open prepayment date. When a prepayment window is available, Chatham will make every effort to arrange the defeasance bonds so that they are only valid until the beginning of the prepayment window.

Who are the additional parties involved in a defeasance and what do they do?

  • Loan servicer: The loan servicer will want a notice of default as well as an up-front payment from the borrower. They give official copies of the loan documentation, as well as an amortization plan for the loan amount. Following defeasance, they continue to pay the loan’s interest and principal. Loan servicer’s counsel: The loan servicer retains the services of a law firm to represent them in the defeasance action. Defeasance forms are drafted by the loan servicer’s counsel, due diligence materials are collected, and some features of the transaction are approved by the loan servicer’s counsel on their behalf. Rating agencies: Rating agencies may conduct an assessment of big defaults to ensure that the default will not result in a downgrading of the securitization pool. The defeasance procedure might be delayed by as much as 10 business days due to an assessment by a rating agency. Defeasance bonds are held in a limited account by a securities intermediary, which then transfers the cash earnings from the bonds to the loan servicer, who uses the funds to make the remaining loan installments. Securities intermediary: A report is issued by an independent certified public accounting company attesting that the cash collections from the portfolio of defeasance bonds would be adequate to cover all remaining loan installments. Defeasance bonds are retained by the successor borrower, which is a single-purpose, bankruptcy-remote limited liability company (LLC) created to accept financial obligation for a loan from the borrower while keeping ownership of the defeasance bonds
  • Defeasance paperwork are reviewed by the successor borrower’s counsel, who files the necessary forms to incorporate the successor borrower corporation and files the defeasance filings. Company that handles the underlying refinancing or sale also handles title and escrow for the defeasance
  • This is known as the title company loophole. Client representation: The majority of borrowers retain the services of an attorney to evaluate the defeasance filings and aid them in delivering the due diligence materials to the loan servicer.

Learn more about malfeasance parties and the procedure they use, as well as frequent difficulties they encounter.

Who sets the transaction fees for these parties?

The fees charged in a defeasance are determined by the parties engaged in the case. Any estimate of transaction costs is based on prior experience and conventional charge schedules. If you have any questions, please contact us. If numerous loans in the same securitization are defeased at the same time, certain parties will provide a discount on their costs.

How can I make debt extinguishment easier and less costly in the future?

Although defeasance may be required under the old loan, Chatham may assist clients on how to obtain more borrowers-friendly defeasance and prepayment wording on new debt. Certain particular defeasance provisions can be modified during the negotiating time prior to the start of the origination process. For example, default portfolio purchasing and successor borrower rights, as well as the structure and content of the bond portfolio required, are among the most significant considerations. Defeasance can also be avoided entirely by opting for a yield maintenance prepayment penalty or even by adopting a floating-rate loan, for which Chatham provides interest rate risk management techniques that are tailored to the borrower’s needs.

Defeasance consultants work as a component of Chatham’s worldwide real estate financial risk management division, assisting commercial and multifamily real estate investors with common but complicated capital markets concerns.

What Is a Defeasance Transaction? (article by Steve Benson)

October 2007DefeasanceWhat isa defeasance transaction, and why are we hearing so much about it lately?
The concept of “defeasance” originated in the municipal bond market. In the 1990�s,the concept was adapted to the commercial real estate market in response to theincreasing securitization of fixed-rate loans. To make these securitizationsmore attractive to investors, true prepayment of loans was restricted, enablingpredictable cash flows. Loan documents first included defeasance provisions inabout 1998 to create an avenue for borrowers to exit a securitized loan for asale or refinance.Defeasance is a substitution of collateral. The borrower uses proceeds from arefinance or sale to purchase a portfolio of securities that is sufficient tomake the remaining debt service payments required by the loan. The securitiesare pledged to the lender who releases the real estate from the lien of themortgage. The loan, however, is not paid off. The note remains outstanding, butis assigned by the borrower to a successor borrower, who makes the ongoing debtpayments (cash flow comes from the securities).The process typically involves a loan servicer, attorneys, an accountant (whodetermines what the �basket� of securities will be composed of), ratingagencies, a securities intermediary, a title/escrow company, the refinancelender or the buyer’s lender, and usually, a defeasance consultant. A defeasancegenerally takes about thirty days to complete; coordinating all the parties anddocuments is the defeasance consultant�s job.Forborrowers with loans securitized in the commercial mortgage-backed securities (CMBS)market-many of which prohibit mezzanine financing and trueprepayment-defeasance can be the only mechanism borrowers can use forextracting equity. The ability to extract equity due to increased propertyvalues may outweigh the costs incurred from defeasing the loan. Forexample, consider a multi-family property, which was purchased using a CMBS loanand was worth $20M (let’s assume that the loan was 75% or $15M). Now, 5 yearslater, the property, in a market like Arizona, may be worth $30M. While apurchaser may buy the property subject to the existing loan (if the originalloan documents allow it), the new buyer may be unhappy with a loan with only 50%leverage. If the loan prevents subordinate or mezzanine financing and prohibitstrue repayment, then defeasance-allowing the new buyer to obtain a loan withbetter leverage-can be an attractive solution. The owner/seller has to weighthe costs of defeasance against the desire to extract equity from theproperty.The costassociated with the defeasance is made up of two components: the securities costand the transaction fees. The cost to purchase the securities is a function ofthe spread between the interest rate on the loan to be defeased and the yield onthe securities portfolio on the date the securities are purchased. The actualcost of the securities is not determined until they are purchased at closing.Transaction costs include the fees of the various parties involved in thedefeasance transaction.These materialsare designed to provide general information prepared by professionals in regardto the subject matter covered. It is provided with the understanding that theauthor is not engaged in rendering legal, accounting, or other professionalservice. Although prepared by professionals, these materials should not beutilized as a substitute for professional service in specific situations. Iflegal advice or other expert assistance is required, the service of aprofessional should be sought.

Defeasance Clause: Definition And Overview

Loans are available in two varieties: secured loans and unsecured loans. Unsecured debt is generally seen on smaller-balance financial instruments, such as credit cards, and is more difficult to collect. Most lenders demand borrowers to put up collateral to secure substantial quantities of money for high-ticket purchases such as a home before they would lend the money. In the majority of house purchase transactions, a buyer obtains a mortgage to finance the purchase of the home, and the mortgage loan is secured by the same property that was used to secure the purchase of the home.

Instead of using the home as collateral for the mortgage, in a lien theory state, a security deed is utilized to transfer legal ownership from the borrower to the bank at closing.

It is, in fact, difficult to understand.

To be honest, the only time you’ll want to take a close look at your legal rights and what you’re entitled to (legally) is if your mortgage loan is foreclosed or if you fail on your mortgage loan.

Commercial Real Estate: Defeasance Services

When it comes to defeasance, Wells Fargo can assist you with the complicated procedure. Individual debtors, institutional investors, financial institutions, investment banks, and third-party investment groups are among the customers we represent in defeasance cases.

The Wells Fargo advantage

  • Team with a lot of experience. Since 2004, we’ve been involved in defeasance transactions of various kinds. We have completed more than 7,500 defeasance transactions totalling more than $88 billion in the previous 12+ years. The defeasance consultant on more than half of those deals was one of our employees. Process has been simplified. Our ability to serve in several defeasance positions on your behalf reduces the burden of involving extra parties in the process and allows us to deliver a more complete strategy.
  • Costs are being reduced. We provide free quotations based on real-time pricing, and our excellent relationships with third-party vendors allow us to bargain on your behalf and pass the savings on to you. We also provide a variety of services, including

It is the procedure by which the real estate collateral that secures a mortgage loan is substituted with government securities in order to release the real estate collateral while maintaining the payment stream for the mortgage debt, which is known as defeasance. The release of the initial collateral allows the borrower to sell or refinance the real estate that served as collateral.

Defeasance and how it works

For a quick summary, check out this shortYouTube video. Please note that we are providing these links to external websites only for your convenience. Wells Fargo does not support and is not liable for the content, links, privacy policies, or security policies of these third-party websites or services. LRC-0321

Defeasance in Real Estate: Equity & Mortgage Clauses

The term “adefeasance clause” refers to a language in a mortgage agreement that specifies that the borrower will be awarded full ownership of the property after the mortgage obligations have been satisfied. So, after Frank has paid off a property, he becomes the sole owner of that property, and he will no longer be able to foreclose on that property. Because there is no longer a debt obligation on the property, the value of the property equals the amount of equity in the property.

Purpose of Using Defeasance Clauses

Consider the following scenario: Frank has an outstanding balance of around $81,000 on a mortgage with a 5 percent interest rate, and he has 20 years of payments remaining on the loan. The fact that he originally took out a 30-year loan results in a monthly payment of $537. However, the lender he wants to utilize demands that he be the only person listed on the title in order for him to borrow money against the property in order to make upgrades and maybe place a down payment on another building.

This is due to the fact that commercial loans are generally securitized, or packaged along with other loans, to create an investment vehicle.

Prepayment penalties deter borrowers from paying their loans off early and assist in covering the costs of payments to investors when borrowers do pay their loans off early, as described above.

Understanding Defeasance in Five Minutes

Defeasance can be defined as the replacement of collateral in its most basic form. In the field of commercial mortgage-backed securities (CMBS), replacement refers to the process through which a borrower replaces the real estate that secures a loan with a portfolio of securities issued by the United States. The portfolio is intended to yield the same amount of debt payment as the initial collateral throughout the course of the loan’s duration. This enables the lien on the original collateral to be discharged as a result of the transaction.

There’s some terrible news and some good news.

The good news is that the process is relatively simple. The good news is that Two-fold. First and foremost, this essay will provide you with sufficient knowledge to comprehend:

  • Defeasance is utilized for a variety of reasons. The parties who are in control of the process
  • The mechanics of the procedure, as well as
  • The following are some things that borrowers should keep in mind while dealing with defeasance:

The second piece of good news is that Because the process is so time-consuming, borrowers frequently hire professional consultants whose sole responsibility is to handle all of the heavy lifting, allowing borrowers to reap the benefits of defeasance without having to learn anything about the procedure. I’m guessing that if you’re still reading this, you didn’t instantly click away to employ one of these consultants and are interested in learning more about the process for yourself instead. Good.

Why Is Defeasance Used?

When investors purchase commercial mortgage-backed securities (CMBS), they anticipate receiving a consistent cash flow with a set yield for a specified length of time. Therefore, they don’t want borrowers to have the option of paying off their loans early, even if doing so would result in a prepayment penalty, because doing so would cause the investor’s expectations to be disrupted. A recent article in the American Bar Association’s “Business Law Today” magazine stated that lenders want to give borrowers the ability to prepay their loans in order to either: (1) “unlock” equity built up in the property (through the sale of the property or refinance with a larger loan), or (2) refinance with a lower interest rate (such as refinancing at a lower interest rate).

A major reason why CMBS investors are pleased is that the original note has not been terminated, and while the collateral has changed from real estate to a portfolio of securities, the portfolio has been designed to generate the same loan payments as if the original collateral had not been terminated.

assets are less risky than real estate, which makes them a more attractive investment.

What Rules Control Defeasance Rights?

Mortgage or loan documents, which differ from one lender to another, detail the borrower’s right to defease, the process by which he or she can appoint a successor borrower (which is a part of the process described below), the types of securities that can be included in the portfolio, and the conditions of defeasance. Generally, a borrower does not have the right to defease in the absence of defeasance wording in the loan agreement. Here’s an example of defeasance language in its most basic form.

Treasury bonds but also other agency securities that may have a greater yield than U.S.

As Wells Fargo suggests, “borrowers should propose that the alternative collateral include additional U.S.

In most cases, these assets have a greater return than treasuries, which lowers the cost of obtaining substitute collateral, and thus lowers the prepay penalty.” For the second time, borrowers may wish the original loan agreements to include provisions for both defeasance and yield preservation (a form of prepayment discussed below).

  1. In some market situations, yield maintenance may be more cost-effective than increasing production.
  2. The holders are Real Estate Mortgage Investment Conduits (REMICs), and they are subject to the rules of the Internal Revenue Service and the laws of the United States Treasury.
  3. The mortgage release cannot take place within two years of the date the loan was securitized.
  4. 2.
  5. Three, the substitute collateral must consist “exclusively of government securities (as defined in Section 2(a)(16) of the Investment Company Act of 1940, as amended (15 United States Code 80a-1),” according to the Investment Company Act.
  6. government liabilities as well as some debt obligations of FNMA and FHLMC, among others.

This criteria might be met through a sale or refinance. Contrary to popular belief, it is typical for lenders that do not normally pool their loans to include defeasance clauses in their loan contracts in order to be able to securitize the loan later if they so choose.

The Defeasance Process

A borrower is contemplating defeasance, according to the loan documents. What’s his initial move going to be? What happens after that? Let’s go over the steps one by one. Process that takes around 30-45 days to finish on average (though it will only take you 3 minutes to read this summary).

1. Contact Defeasance Consultant – Is Defeasement AllowedAppropriate

The most straightforward approach to assess if defeasement is permitted and acceptable for a borrower is to talk with someone who deals with them on a daily basis: a defeasement consultant. It is possible for the expert to begin their initial examination with as little as the address of the property. They can use this information to get from public records the mortgage that encumbers the property as well as the defeasement conditions included within it. However, if a borrower can submit all of the necessary loan documentation, the procedure can be expedited.

Loan applicants can also make an educated guess on their own utilizing an online defeasement calculator, such as the one available here.

2. Notice and Deposit

The borrower notifies its loan servicer of its plan to defease and provides them with a good faith deposit if both the borrower and the consultant believe that defeasement is the most appropriate alternative. Some of the costs spent by the borrower during the procedure will be compensated by the deposit. In most cases, borrowers must give at least 60 days notice of their plan to foreclose, however lenders may agree to a shorter or longer notice period.

3. Defeasement Consultant’s RolePlayers in the Process

The consultant works on behalf of the borrower and is in charge of coordinating the activities of all of the participants in the show, including:

  • Borrower, Loan Servicer, Securities Intermediary (or custodian), Accountant, Rating Agencies, Escrow Agent/Title Insurance Company, and Attorneys are all examples of parties involved in a loan transaction.

The borrower is responsible for the costs of these third parties, which can range from $50,000 to more than $100,000. Because of this, the cost of the defeasance is tax deductible, as long as the deduction is claimed within the year in which the defeasance was committed. Fortunately,

4. Lender Begins Review

Typically, the lender will prepare the defeasement agreement and send it, as well as other paperwork, to the borrower and consultant for signature before proceeding with the transaction. They will also request that the borrower submit any documentation that they deem required for the lender’s inspection.

5. Form Successor Borrower

While the original loan will remain in place, the borrower will be released from its loan obligations at the conclusion of the transaction, with its responsibilities being assigned to a “successor borrower.” The successor borrower is a one-time entity established only for the purpose of assuming the loan’s payment obligations as well as ownership of the replacement collateral, if any.

6. Structure Defeasance Collateral – Securities Portfolio

The defeasance consultant is in charge of coordinating the design of the securities portfolio.

Some consultants organize a competitive auction for the acquisition of replacement collateral by the borrower, in which case the borrower wins.

7. Accountant’s Review of Defeasement Collateral

In conjunction with the defeasance consultant, the securities portfolio is designed. When a borrower purchases replacement collateral, some experts organize a competitive auction to determine who will get paid the most.

8. Ratings Agencies Analysis

The defeasance consultant is responsible for coordinating the design of the securities portfolio. Some advisors conduct a competitive auction for the acquisition of substitute collateral by the borrower.

9. Closing – Purchase Securities, Assign Loan and Defeasement Collateral, Release Lien

The defeasance consultant is in charge of coordinating the creation of the securities portfolio. Some advisors arrange a competitive auction for the acquisition of replacement collateral by borrowers.

10. Payment of Residual Value

As a consequence of the “float value” and “prepayment value” of the assets held by the intermediary, the securities held by the intermediary may produce more money than is required to satisfy the payment obligations of the successor borrower. In finance, this surplus is referred to as “residual value,” and depending on the circumstances, it may be retained by the successor borrower or split between it and the original borrower. This is because there will be a brief amount of time between when revenue from matured securities is put in the defeasement account and when the intermediary makes loan payments, thereby creating a float value.

Prepayment value is formed when the loan documents let the borrower to pay off the loan many months ahead of schedule.

Because the parties will be negotiating who will receive a share of the residual value, the parties will also be negotiating when this value will be distributed.

Other debtors may not be entitled to a portion of the residual value until the loan has been fully repaid.

What Is The Difference Between Defeasance And Yield Maintenance?

Defeasance and yield maintenance are both operations that are employed to achieve the same purpose (i.e., the release of the lien on the original collateral), but they are performed in a different way. In contrast to defeasance, which is the replacement of the original collateral while the original loan remains in place, yield maintenance is the payback of the original loan amount. The prepayment is comprised of I the outstanding sum on the original note, plus (ii) a penalty for early repayment.

It does not have any accountants, credit rating agencies, or securities intermediaries (and none of their attorneys).

However, because of the potential benefits that defeasance might provide, maintaining yields may not be the most financially sensible choice.

A defeasance expert may look at current interest rates, bond yields, and transaction expenses and provide recommendations on which strategy is the most advantageous.


Isn’t it a piece of cake? Well, maybe not, but as previously said, as long as a borrower uses the services of an expert defeasement adviser, the procedure might appear to be straightforward. As is usually the case, because this material is offered just for your information and does not constitute legal advice, if you have any particular defeasement questions, it is advisable to consult with an attorney. Is there anything we’ve missed? Have you ever been the victim of a defeasement? If you have any questions, comments, or tales to share, please feel free to post them in the comments area.

Leave a Reply

Your email address will not be published. Required fields are marked *