Defeasance penalty

What is defeasance?

Defeasance is a type of prepayment provision commonly found in commercial mortgage-backed securities (CMBS) loans. It allows a borrower to be released from a mortgage obligation by substituting the mortgaged property as collateral with other collateral, typically U.S. Treasury securities. This is different from a traditional prepayment penalty, which is simply a fee paid to the lender for paying off the loan early. Defeasance is more complex and often more expensive.

Understanding the defeasance penalty

The defeasance penalty is essentially the cost of replacing the income stream the lender would have received from the original mortgage with the income stream from the substitute collateral (the U.S. Treasury securities). This typically involves purchasing a portfolio of government securities that generate enough cash flow to cover the remaining debt service payments on the loan. The difference in cost between the mortgage and the Treasuries is the penalty, plus the cost of all the legal and administrative fees.

Therefore, the defeasance penalty isn't a set percentage but is dependent on the interest rate environment at the time of defeasance. If interest rates have fallen since the loan was originated, the cost of the Treasury securities will be higher, leading to a larger defeasance penalty. Conversely, if interest rates have risen, the cost will be lower.

Calculating the defeasance penalty: an example

Let's illustrate this with an example. Suppose a company took out a $10 million CMBS loan with a 5% interest rate. Several years later, they want to sell the property and need to defease the loan. At that time, similar-maturity U.S. Treasury securities are yielding 3%. To generate the same cash flow as the original mortgage, the company will need to purchase a larger amount of Treasury securities than the outstanding loan balance.

The calculations involve discounting each future loan payment back to its present value using the current Treasury yield curve. This process determines the exact amount of Treasury securities needed to replicate the loan's cash flow. to the cost of the securities, there are significant administrative costs, including legal fees, accounting fees, and servicer fees. A typical defeasance can easily cost tens of thousands of dollars just in fees.

Why defeasance exists

Defeasance is a common feature of CMBS loans because it allows the lender to maintain the predictable cash flow required by the securitization process. When a mortgage is securitized, it's bundled with other mortgages and sold to investors in the form of bonds. These bonds are rated based on the expected cash flow from the underlying mortgages. Traditional prepayment would disrupt this cash flow, potentially impacting the bond ratings and investor returns. Defeasance ensures that the cash flow remains consistent, even if the borrower wants to exit the loan early.

From the borrower's perspective, defeasance provides a way to dispose of the property without having to pay a potentially large prepayment penalty in the traditional sense. While defeasance can be expensive, it offers a predictable and structured way to exit the loan, which can be crucial for certain business transactions.

Alternatives to defeasance

While defeasance is a common prepayment option for CMBS loans, it's not the only one. Other options may include:

• Yield Maintenance: A calculation that determines the present value of the remaining loan payments, discounted at a rate that is usually slightly higher than the Treasury yield. This is generally less complex than defeasance.
• Prepayment Penalty: A fixed percentage of the outstanding loan balance. This is often used in non-CMBS commercial loans.
• Assumption: Where another qualified buyer assumes the existing loan. This requires the lender's approval and the buyer meeting certain creditworthiness criteria.

The best option depends on the specific terms of the loan agreement and the current market conditions. Borrowers should carefully evaluate all available options before making a decision.