Defeasance is a commercial mortgage prepayment method that releases a property from its loan by substituting a portfolio of government securities that replicates the loan's remaining payments. The borrower does not pay off the loan directly. Instead, the Treasury portfolio makes the scheduled payments in its place, most often on securitized CMBS loans that prohibit direct prepayment.
How Does Defeasance Work?
Defeasance works by replacing real estate collateral with a portfolio of U.S. Treasury securities engineered to produce the exact remaining principal and interest payments of the loan. The lender releases its lien on the property, the securities are pledged in its place, and the loan continues on paper while the bonds service it. This lets a borrower sell or refinance without directly prepaying.
Per Commercial Real Estate Loans and Chatham Financial, defeasance substitutes collateral rather than retiring debt, which is why CMBS loans that forbid prepayment still permit a sale. The borrower buys Treasuries sized to cover every remaining payment through the loan's maturity or open window, then transfers them to a successor borrower that assumes the loan.
Step | What happens |
Lockout expires | Direct prepayment is barred, usually for the first 24 to 36 months |
Portfolio priced | Treasuries are sized to replicate all remaining loan payments |
Collateral swapped | Securities replace the property; the lender releases its lien |
Property freed | The borrower sells or refinances the now-unencumbered property |
Per APERS and Chatham Financial, CMBS loans typically follow a lockout of 24 to 36 months, then a defeasance or yield maintenance window, then a 3 to 6 month open period near maturity when the loan can be prepaid at par. Defeasance is only available inside that middle window.
Why Defeasance Matters
Defeasance matters because it determines the true cost of exiting a CMBS loan early, which can make or break a sale or refinance. When market rates sit below the loan's coupon, the Treasury portfolio costs more than the loan balance, and that premium is a real transaction cost the seller absorbs. Misjudging it can erase the gain from a well-timed sale.
Per Scotsman Guide and Chatham Financial, third-party defeasance costs, covering legal, accounting, and consultant fees, commonly run in the tens of thousands of dollars, often $50,000 to $70,000, on top of the securities cost. In a rare inversion, when Treasury yields exceed the loan coupon, the portfolio can cost less than the balance, producing a negative defeasance in which the borrower receives cash at payoff.
The quotable point for an operator: defeasance cost is driven by the spread between the loan coupon and Treasury yields, so the same loan can carry a large premium in one rate environment and a discount in another.
Example
A borrower wants to sell a property securing a $5,000,000 CMBS loan at a 6.5% coupon with 36 months remaining. The portfolio must fund 36 monthly interest payments plus the $5,000,000 balloon at maturity. Its cost is the present value of those cash flows discounted at the current 3-year Treasury yield, which in this example is 3.5%.
Item | Value |
Loan balance | $5,000,000 |
Loan coupon | 6.5% |
Months remaining | 36 |
Monthly interest payment | $27,083 |
Discount rate (3-year Treasury) | 3.5% |
Coupon-to-Treasury spread | 3.0% |
Because the 6.5% coupon far exceeds the 3.5% Treasury yield, the securities that produce those above-market payments cost more than the $5,000,000 balance. The present value of 36 payments of $27,083 plus the $5,000,000 balloon, discounted at 3.5%, is roughly $5,427,000, so the defeasance premium is about $427,000. Add third-party fees of $50,000 to $70,000, and the total approaches $490,000, all of which the seller must clear before netting sale proceeds.
Variations and Edge Cases
Defeasance behavior shifts with the rate environment, the loan documents, and timing. The table below covers the variants an operator should confirm before committing to a sale or refinance.
Variant | Treatment |
Premium defeasance | Coupon above Treasury yields; portfolio costs more than the balance, the common case |
Negative defeasance | Treasury yields above the coupon; portfolio costs less, and the borrower receives cash |
Open period | Final 3 to 6 months usually allow prepayment at par with no defeasance |
Successor borrower | A special-purpose entity assumes the loan and holds the securities to satisfy the covenant |
Agency defeasance | Fannie Mae and Freddie Mac loans allow defeasance, sometimes requiring agency securities |
The most common mistake is treating defeasance cost as fixed. It moves daily with Treasury yields, so a quote from one week can be materially wrong the next. The cost should be re-priced close to closing, and the sale or refinance economics stress-tested against a rate move, before the deal is committed.
Defeasance vs Yield Maintenance
Defeasance is often confused with yield maintenance, and both compensate a lender for early payoff, but they work differently. Defeasance substitutes a Treasury portfolio for the property, so the loan technically continues. Yield maintenance is a cash prepayment penalty equal to the present value of the lender's lost interest, after which the loan is retired.
The practical difference is mechanism and flexibility. Yield maintenance is a single payment that ends the loan, and it is simpler and faster to execute. Defeasance is a securities transaction requiring a successor borrower, consultants, and weeks of work, but it can be cheaper in some rate environments and is often the only option a CMBS loan permits. Which applies is dictated by the loan documents, not the borrower's preference.
Frequently Asked Questions
What is defeasance in commercial real estate?Defeasance in commercial real estate is a prepayment method that releases a property from its loan by substituting a portfolio of U.S. Treasury securities that replicates the loan's remaining payments. The borrower does not pay the loan off directly. Instead, the securities service it, most often on CMBS loans that prohibit direct prepayment.
How much does defeasance cost?Defeasance cost has two parts: the securities premium and third-party fees. When rates sit below the loan coupon, the Treasury portfolio costs more than the balance, often several percent of the loan. Third-party legal, accounting, and consultant fees commonly run $50,000 to $70,000, per Scotsman Guide and Chatham Financial.
What is negative defeasance?Negative defeasance occurs when Treasury yields exceed the loan's coupon, so the securities that replicate the loan's payments cost less than the outstanding balance. In that case the borrower receives cash at payoff rather than paying a premium. It is rare and appears only when the yield curve moves above older, lower loan coupons.
Is defeasance the same as yield maintenance?No. Defeasance substitutes a Treasury portfolio for the property, so the loan continues on paper, while yield maintenance is a cash penalty that retires the loan outright. Yield maintenance is simpler and faster, but defeasance is often the only prepayment method a CMBS loan permits, and which applies is set by the loan documents.
Related Terms
Permanent Loan
Bridge Loan
Loan to Value Ratio
Debt Service Coverage Ratio
Net Operating Income