Money & Finance › Commercial real estate lending › Prepayment penalties: step-down, yield maintenance, defeasance
Defeasance: swapping the building's collateral for Treasuries
· Concept
Fact, law or dataA rule, statute, definition or measured number.
Instead of paying a loan off early, the borrower buys Treasuries that cover every remaining payment and substitutes them as collateral.
See it on the Money & Finance map →How it works
Steps: give notice, typically 30–60 days. A consultant builds a portfolio of Treasuries whose interest and maturities match each remaining payment through maturity or the open-prepayment date. The borrower buys it, often with refinance proceeds. A successor company set up for the purpose assumes the loan and holds the bonds, and the building's lien is released. Fees for consultants, lawyers, accountants, the servicer and rating agencies can run $50,000–150,000. Most CMBS loans use it; REMIC tax rules allow it only after two years.
Why it matters
The loan stays in the bond pool, so investors keep their cash flows; the owner pays more than the balance when rates have fallen and can pay less when they have risen.
Facts, rules and data
CMBS loan documents and servicer records, REMIC tax regulations, and defeasance consultants' cost calculators; Trepp tracks defeased loans within CMBS deals.
Debates and risks
Whether defeasance will beat a cash penalty depends on rates at exit, which no one knows at signing; many owners learn the cost only years later.
Connections (2)
▸Yield maintenance: paying the lender's lost interest is the cash alternative to Defeasance: swapping the building's collateral for TreasuriesFact, law or data
The connection
Both compensate the lender for lost interest, often by similar amounts. Yield maintenance is a cash payment, and the loan is retired. Defeasance keeps the loan alive, now backed by Treasuries, because CMBS trusts must keep bond payments intact. Defeasance adds third-party fees but can cost less than the balance when rates have risen.
When and why
Yield maintenance is common in life-company and agency loans; defeasance in CMBS loans since the 1990s.
How we know
Loan documents specify which applies; REMIC tax rules explain why CMBS loans favor defeasance.
Debates and risks
Which costs less in a given case depends on the yield curve and fees at exit, so owners often compare quotes before choosing a loan.
▸Defeasance: swapping the building's collateral for Treasuries replaces the building's collateral with US Treasury securitiesFact, law or data
The connection
The borrower buys a set of Treasury notes and strips whose payments match each remaining loan payment, and the lien moves from the building to the bonds. When Treasury yields are high the bonds are cheap, so defeasance can cost less than the loan balance; when yields are low, it costs more.
When and why
Mainly in CMBS loans; the Treasuries are bought in the open market through the defeasance consultant's broker.
How we know
Defeasance closing statements and consultants' cost calculators, which price the portfolio at current Treasury yields.
Debates and risks
Some loans allow cheaper agency bonds instead of Treasuries; which securities are allowed can shift the cost noticeably.