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Defeasance Definition: How Defeasance Relates to CMBS Loans

Defeasance Allows Borrowers to Prepay Conduit Loans

Borrowers often consider conduit loans’ strict prepayment penalties to be one of their major downsides. Many CMBS loans must be prepaid in a process called defeasance, which involves a borrower purchasing alternative securities, often U.S. Treasury bonds, to replace the collateral and interest income that the lender will lose as a result of prepayment. Defeasance can be a complicated process, the details of which will typically be spelled out in a borrower’s loan agreement.

How Defeasance Actually Works for CMBS Borrowers

In order to conduct defeasance properly, borrowers often need a team including one or more lawyers, accountants, and financial advisors in order to assist them through the process. In most cases, a borrower will want to work with an experienced broker-dealer who can tailor a group of securities that can generate sufficient cash flow to make all remaining payments on the loan through maturity. In addition, a securities intermediary will be needed, who can hold the bonds in a separate account (similar to escrow), in the borrower’s name, but for the lender’s benefit. The intermediary will actually make the monthly debt payments to the lender with the cash proceeds of the securities. 

When Is Defeasance a Good Idea?

When determining whether to attempt defeasance, borrowers should look at the interest rates for the securities they will have to buy as replacement collateral. When interest rates for the replacement securities are lower than the interest rate of the loan, the cost of defeasance will exceed the loan’s remaining balance. However, if current interest rates for the replacement securities are lower than the interest rate of the loan, the cost of defeasance will actually be less than the remaining balance of the loan. In this situation, defeasance can actually save a borrower money, at least in theory. However, since borrowers will typically have to pay for the services of several consultants, such as broker-dealers, lawyers, and accountants, defeasance rarely saves borrowers money in practice. In fact, the services of these experts often ends up costing between 10% and 30% of the entire loan balance, which can make defeasance a somewhat expensive process.

Whether defeasance is a good idea also depends on the exact nature of the defeasance stipulations in the borrower’s loan agreement. 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.

Instead of Defeasance, Borrowers May Want to Find a New Buyer to Assume Their Loan

Since defeasance can be so costly, many borrowers may find that it’s more efficient to simply find a buyer who can assume their loan. The vast majority of conduit loans are fully assumable with a small fee, so as long as the original borrower can find a new, qualified borrower for the loan, they can exit the property without conducting defeasance.

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