The term defeasance is generally used to describe a stipulation in a finance contract that voids a bond or loan on a balance sheet in the event of the borrower setting aside cash (or bonds) whose value would be sufficient for servicing the debt. In this scenario, the borrower specifically sets aside an adequate amount of liquidity to pay off the bonds; this causes the outstanding debt and the cash balance to offset each other on a balance sheet – rendering both unnecessary to record.

As part of a commercial mortgage transaction, a defeasance clause grants the borrower the right to secure the title (or deed) for the collateral property once the debt is paid in full. Until that time when the note has been satisfied (paid in full), the financial entity backing the loan retains all rights to the title, maintaining it as collateral towards the associated debt obligation.

Defeasance in action, is the replacement of the collateral of a loan with securities that will provide a lender an equivalent return. The favored and most common type of securities used are fixed-rate government bonds. In most cases, borrowers purchase U.S. Treasury bonds in order to conduct defeasance, though in some cases, other types of government-backed securities are accepted. What truly matters, is that the total value of the bonds is able to provide to the lender, at the very least, the same amount of income as did the loan itself. This is done so that the lender does not experience any loss of income as a result of the borrower prepaying their loan, and thus negating the receival of interest. Prepayment on a multifamily loan is a common occurrence for borrowers who want to sell the property before the term of the loan is up.

Just like a new multifamily or commercial real estate investor would generally rather work with a broker than deal directly with lenders themselves, defeasance generally requires the aid of expert consultants if it is to be executed properly. The concept may sound simple enough, but overall, defeasance can be a somewhat complicated ordeal for the parties involved to work through. Such intricacies include purchasing the exact amount of bonds (equal in value to the loan balance), securing them in the proper way, and recording and filing property for tax purposes. Additionally, there is typically a fair amount of negotiation and communication with the lender that is required throughout the entire process.

Defeasance can be highly beneficial to both borrowers and lenders. For lenders, defeasance removes any risk of repayment and replaces it with returns guaranteed by U.S. Treasury bonds (or, in some cases, bonds issued by Fannie Mae, Freddie Mac, or Ginnie Mae).

From the borrower's perspective, there are also some advantages to defeasance, such as if interest rates are expected to rise, defeasance can be particularly advantageous for a note with a variable rate. By replacing the loan’s collateral with bonds, a borrower doesn’t need to be concerned with rising rates.

Defeasance can also have accounting benefits. By replacing the collateral with securities, the debt is effectively removed from a company’s balance sheet. This makes a commercial real estate investor’s books far less complex when it comes to logging debt service transactions.

The main risks associated with defeasance come down to cost. The process is generally so complex that a team of experienced accountants and legal experts are required to execute everything successfully. As these aren’t single-day transactions — and can take months, depending on the situation — this time factor can make the process itself prohibitively expensive. Additionally, defeasance’s costs are also increased by the intensive capital investment into the replacement collateral — the bonds — used to offset the yields.

From the borrower’s perspective, there are also some risks to defeasance, as it broadly depends on a borrower’s specific situation and wider economic conditions and trends. If interest rates are expected to rise, defeasance can be particularly disadvantageous for variable rate notes.

Defeasance in commercial real estate is a process that allows a borrower to pay off a loan without incurring a prepayment penalty. The process involves replacing the loan with a portfolio of bonds that generate the same cash flow as the loan. This process is complex and requires a team of experienced accountants and legal experts to execute it successfully. It also requires a significant capital investment into the replacement collateral, which are the bonds used to offset the yields. A defeasance consultant is typically hired to conduct the entire process, which includes purchasing the exact amount of bonds, securing them in a custodial account, and filing the necessary paperwork for tax purposes.

Defeasance is tax-deductible, but a borrower (or their original accountant) may not be used to filing the type of paperwork and documentation required for a borrower to take the deduction. Source

The main alternative to defeasance is yield maintenance. Yield maintenance is a prepayment penalty that is designed to compensate the lender for the loss of interest income that would have been earned if the loan had been paid off over its full term. Yield maintenance is calculated by taking the difference between the loan’s original interest rate and the current market rate, multiplied by the remaining principal balance. This amount is then added to the principal balance to be paid off in full.

Yield maintenance is generally less expensive than defeasance, as it does not require the purchase of replacement collateral. However, it does not provide the same level of certainty as defeasance, as the borrower is still exposed to the risk of rising interest rates.

Sources:

• Defeasance or Yield Maintenance: Which Is Better?
• Variable vs. Fixed Loan Interest Rate