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What Defeasance Means and Why It Matters to Investors
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Defeasance is a loan prepayment mechanism used in commercial real estate that allows a borrower to exit a loan without retiring the debt outright. Instead of paying off the balance early, the borrower replaces the property serving as collateral with a portfolio of government-backed securities structured to generate the same scheduled payments the lender expects to receive.
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This matters to investors because many commercial real estate loans — particularly CMBS loans — prohibit or significantly restrict early payoff. When a borrower needs to sell an asset or refinance before loan maturity, defeasance provides a structured, compliant path to release the property lien.
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How Defeasance Works in a CRE Loan
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At its core, defeasance separates the property from the loan. The borrower purchases a set of securities — typically U.S. Treasury obligations or other qualifying government-backed instruments — designed to replicate every remaining loan payment. Those securities are then pledged to the lender as the new collateral, and the original property is released from the mortgage lien.
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The transaction requires coordination across multiple specialized parties and generally takes 30 to 60 days to execute. The loan servicer must approve the collateral substitution, and all parties — including legal counsel, accountants, and a defeasance consultant — must confirm the securities portfolio satisfies the requirements set out in the loan documents.
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Collateral Substitution, Successor Borrower, and Cash-Flow Matching in Defeasance
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The collateral substitution is the foundation of the entire process. Replacement securities are selected specifically to match the timing and dollar amount of each remaining scheduled payment, including the final balloon.
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Many defeasance transactions also require the formation of a successor borrower — a separate legal entity that assumes ownership of the securities portfolio and the ongoing loan obligations. This structure isolates the defeased loan from the original borrower’s balance sheet, a standard requirement in CMBS deals designed to protect the integrity of the securitization trust.
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Cash-flow matching is where most of the cost originates. Because securities must be purchased at prevailing market prices, the total expenditure is sensitive to current interest rates. When rates decline, more capital is required to purchase enough securities to cover future payments.
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When Defeasance Is Used in CMBS, Agency, and Multifamily Deals
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Defeasance is most frequently encountered in CMBS loans, where the loan has been pooled into a securitization trust. In that structure, trust investors expect a defined payment stream, and early payoff is either prohibited outright or subject to strict exit provisions — often defeasance specifically.
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Agency loans originated under Fannie Mae and Freddie Mac multifamily programs may also include defeasance as a permitted prepayment option during specific loan periods. The applicable terms depend on the program and origination year.
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Multifamily investors frequently encounter defeasance provisions on stabilized properties carrying long-term agency debt. In value-add or repositioning scenarios, whether a loan permits defeasance — and at what estimated cost — is a central component of exit strategy modeling.
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Defeasance Costs, Timing, and Key Parties in the Transaction
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The total cost of a defeasance includes the securities portfolio purchase price, defeasance consultant fees, legal fees, accounting fees, servicer charges, custodian fees, and other transaction-related expenses.
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Of these components, the securities portfolio represents the largest line item by a significant margin. Its price moves with interest rates and cannot be locked until the securities are actually purchased. Timing also affects eligibility — most loan documents specify an open period, a defined window during which defeasance is permitted. This window typically opens two to three years after origination and closes 90 to 120 days before the maturity date.
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The key parties typically involved in a defeasance transaction include:
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- Borrower — initiates and funds the transaction
- Loan servicer — approves and oversees the process
- Defeasance consultant — structures the securities portfolio and manages execution
- Attorney — prepares and reviews transaction documents
- Accountant — addresses tax treatment and financial reporting
- Securities broker/dealer — sources the replacement securities
- Custodian — holds the portfolio on behalf of the trust
- Successor borrower — assumes the ongoing loan obligations where required
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Defeasance vs. Yield Maintenance: Which Prepayment Structure Is Better?
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Both defeasance and yield maintenance are prepayment protection mechanisms that preserve the lender’s or bond investors’ expected return when a borrower exits early. They are not interchangeable, and each carries distinct cost behavior based on market conditions.
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Yield maintenance is a cash penalty. The borrower pays an amount equal to the present value of the difference between the loan’s contracted rate and the prevailing Treasury rate, applied to the remaining balance and term. In a rising rate environment, yield maintenance costs tend to decrease; in a falling rate environment, they tend to increase.
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Defeasance cost follows a similar inverse relationship with rates — when rates fall, purchasing the replacement securities portfolio becomes more expensive. However, the two mechanisms can produce substantially different totals depending on the specific loan structure, rate spread assumptions, remaining term, and associated fees.
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There is no universal answer to which is cheaper. A side-by-side calculation at the time of the transaction, using current rate data, is required to determine the lower-cost option. Some loan documents offer a choice between the two; others mandate only one.
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How to Review a Loan for Defeasance Terms Before a Sale or Refinance
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Before committing to a sale timeline or refinance structure, investors and their advisors should review the loan agreement — and, for CMBS loans, the applicable pooling and servicing agreement (PSA) — for the following:
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- Prepayment provisions — confirm whether defeasance is permitted, required, or an option alongside yield maintenance
- Open period dates — identify when the defeasance window begins and ends
- Successor borrower requirements — determine whether a separate legal entity must be established
- Approved securities types — some loan documents restrict which instruments qualify as replacement collateral
- Servicer notice and approval process — understand required lead times and documentation standards
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Early review — ideally during the due diligence phase of an acquisition — provides a clearer picture of exit costs and scheduling constraints. Waiting until a sale is already under contract compresses execution time and reduces flexibility on closing timelines.
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Defeasance Pros, Risks, and Decision Factors for Borrowers
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Defeasance provides a defined, contractually compliant path to release a property lien when the loan otherwise prohibits prepayment. For investors holding CMBS or agency debt, it enables a clean transfer of title without violating loan terms.
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That said, several risk factors and decision points apply before proceeding:
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Market timing risk — defeasance cost is inversely correlated with interest rates. In a low-rate environment, assembling the securities portfolio is more expensive.
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Execution timeline — most transactions take 30 to 60 days to complete. In competitive sale environments, this timeline can create complications for contract closing schedules.
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Successor borrower setup — forming and administering a successor entity adds cost and legal complexity, though specialized consultants typically manage much of this work.
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Loan document interpretation — misreading or overlooking key terms can delay the transaction or create compliance issues with the servicer.
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Cost unpredictability — unlike a fixed prepayment fee, defeasance cost is market-driven and cannot be confirmed until securities are purchased.
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Borrowers comparing defeasance against yield maintenance or other exit alternatives should model both scenarios using current rate data before committing to an approach.
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FAQ
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What is defeasance in commercial real estate?
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Defeasance is a process that releases a borrower from a loan secured by a property by replacing the real estate collateral with a portfolio of government-backed securities that produces the remaining loan payments.
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Why is defeasance used instead of paying off a loan early?
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It is commonly used when loan documents restrict prepayment, especially in CMBS and certain multifamily loans. Defeasance allows a sale or refinance while preserving the lender’s or bond investors’ expected cash flow.
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How is defeasance different from yield maintenance?
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Yield maintenance is a prepayment charge paid to compensate the lender for lost yield, while defeasance substitutes collateral and keeps the original payment stream in place. Which is cheaper depends on rates, timing, fees, and the loan structure.
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What does defeasance usually cost?
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Total cost can include the price of replacement securities, defeasance consultant fees, legal fees, accounting work, servicer and custodian charges, and other transaction expenses. Costs are highly sensitive to interest rates and the remaining loan term.
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Who is involved in a defeasance transaction?
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Typical parties include the borrower, servicer, defeasance consultant, attorney, accountant, securities provider, custodian, and often a successor borrower that assumes the substituted collateral obligations.
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