Defeasance

Defeasance, or defeazance, in law, is an instrument which defeats the force or operation of some other deed or estate; as distinguished from condition, that which in the same deed is called a condition is a defeasance in another deed.

A defeasance should recite the deed to be defeated and its date, and it must be made between the same parties as are interested in the deed to which it is collateral. It must be of a thing defeasible, and all the conditions must be strictly carried out before the defeasance can be consummated.

Defeasance in a bill of sale is the putting an end to the security by realizing the goods for the benefit of the mortgagee.  It is not strictly a defeasance, because the stipulation is in the same deed; it is really a condition in the nature of a defeasance.

Nearly every fixed-rate conduit loan originated since 1998 requires the borrower to defease the loan in order to sell or refinance.  Defeasance has become so prevalent in securitized loans that life insurance companies, HUD, and others seeking to preserve the ability to securitize their loans have incorporated defeasance into their form loan documents, as well.

Put simply, defeasance is a substitution of collateral.  Typically, the borrower uses proceeds from a refinance or sale to purchase a portfolio of U.S. government securities.  The redemption of principal and interest from the securities is sufficient to make all the remaining debt service payments, the lender releases the real estate from the lien of the mortgage, the note remains in place, and payments are made as scheduled.

As one might imagine, structuring a defeasance is no easy task.  It involves negotiating with a host of professionals, from attorneys and accountants to servicers, trustees, and rating agencies.  More importantly, it involves finding and buying qualified Treasury or comparable securities the mature prior to, but as close as possible to, each remaining payment date.  For a loan with a five (5) year remaining term, the defeasance collateral could consist of as many as forty individual securities.

Defeasance of a Securitized Commercial Mortgage

Defeasance of a securitized commercial mortgage is a process in commercial real estate finance by which a borrower substitutes other income-producing collateral for a piece of real property to facilitate the removal of an existing lien without pre-paying the existing note.  Generally, a basket of United States treasury obligations is the only collateral "acceptable" for this type of substitution, although some securitized loan documents do allow for the use of agency securities that are less costly.  The original note remains in place after a defeasance, but it is collateralized and serviced by the substituted securities instead of the real estate.  These securities are held by a "successor borrower" entity which uses the income from/disposition of the securities to make the monthly debt service payments and balloon payment on the mortgage being defeased. The premium a borrower pays to defease (what some refer to incorrectly as a "penalty") is the total cost of purchasing the securities less the outstanding balance on the loan.  Payments to CMBS (commercial mortgage backed securities) bondholders are not disrupted, and the borrower can sell or place a new first lien on the property.  Unlike yield maintenance, defeasance is neither a type of prepayment nor a prepayment penalty.

This type of defeasance is a relatively new methodology.  Looking back to the mid-1990’s, it was unheard of to defease a securitized commercial mortgage.  Securitized lenders (colloquially known as "conduits") focused primarily on the securitization of residential mortgages, while commercial mortgage debt was still the bastion of large life insurance companies and commercial banks.  But times quickly changed, and at the end of 1996, there was an explosion in the demand for call-protected bonds backed by commercial real estate.  This demand helped make conduit mortgage pricing on commercial mortgages more competitive than ever, and in 1997, almost $45 billion in CMBS were issued, followed by $80 billion in 1998.  While this drastic upward swing was somewhat of an anomaly, it illustrated the quantity of bargain priced "conduit money" that became available in the industry to finance commercial real estate.  With that shift came a change in borrower’s attitudes toward conduits, when commercial property owners realized that securitization allowed risk to be allocated more efficiently (translating into lower costs of capital for borrowers).  This trend has persisted in the industry.  In 2004, roughly 40% of commercial real estate debt issuance (around $91 billion) was financed through the issuance of CMBS.

Defeasance vs. Yield Maintenance

Yield Maintenance

  • Yield Maintenance is an actual "Payoff" of the existing loan
  • There is always a minimum prepayment of at least 1% of the loan balance
  • There has been no standardization of yield maintenance language
  • Complex language leads to conflicting interpretations and inflated premium calculations
  • Servicer’s calculation is usually binding "absent manifest" error

Defeasance

  • Defeasance is a 30 day process involving a substitution of collateral. The property is released from the lien of the mortgage, the Note stays intact and all of the remaining P&I Payments are made from the securities as they redeem
  • Defeasance is a neutral process with no minimum fee and the potential to defease at a discount
  • There has been a high level of standardization of defeasance provisions
  • Often less costly than Yield Maintenance, particularly when erroneous Yield Maintenance calculations are considered or market conditions are ripe for defeasance discount

Yield maintenance is a prepayment of the loan with cash.  The yield maintenance penalty is calculated by the lender which can take several weeks from the date it is requested, yield maintenance language also varies greatly from loan to loan and is subject to a number of different interpretations.  Even if the borrower believes that the servicer interpreted the yield maintenance language correctly or chose the interpretation that was least favorable to the borrower, the servicer’s calculation of the amount the borrower owes typically may not be challenged absent "Manifest error".  While yield maintenance does not have the transaction costs per se, the yield maintenance penalty is always at least 1% of the loan balance.  Defeasance, on the other hand, is a substitution of collateral that generally takes less than 30 days to complete.  Defeasance provisions are fairly consistent and the process has been standardized across the industry.  Additionally, there is always the possibility that a loan can be defeased at par or even at a discount if yields on government treasuries exceed the interest rate in the note, which is a distinct possibility over the ten(10) year term of a loan originated today at 5% or 6%.

Defeasance Costs

Rating Agency
0 - $15,000
Special Servicer
0 - $5,000
Successor Borrower
$8,000 - $12,000
Servicer Processing
$7,500 - $27,500
Servicer legal
$12,500 - $25,000
Special Counsel
$3,500 - $10,000
Accountant
$4,000 - $10,000
Custodian/Securities Intermediary
$6,000 - $10,000
Commercial Defeasance
$15,000 - $20,000
Average Transaction Costs
$55,000