A defeased loan is a commercial mortgage whose original property collateral has been replaced with a portfolio of U.S. government securities that generates enough cash to cover every remaining scheduled payment. The borrower walks away from the property free and clear, but the loan itself keeps running on its original schedule until maturity, now secured by the securities instead of the real estate. Defeasance appears almost exclusively in commercial real estate, and most often on loans that have been packaged into Commercial Mortgage-Backed Securities (CMBS), where straightforward prepayment is either prohibited or heavily penalized.
Why CMBS Loans Get Defeased Instead of Paid Off
CMBS loans are pooled and sold to bond investors who bought in expecting a specific stream of payments at a specific rate over a specific timeline. Letting a borrower simply prepay would disrupt that revenue stream and force investors to reinvest at whatever rates are available, potentially at a loss.
To protect that certainty, CMBS loan documents include a lockout period, typically two to five years from origination, during which prepayment is not allowed at all. After the lockout expires, the loan usually permits an early exit through either defeasance or yield maintenance, depending on what was negotiated at origination.
Defeasance solves the investor problem cleanly. The bondholders keep receiving their scheduled payments, now funded by the securities portfolio, and the borrower is released from the property. The securitization trust never sees a change in cash flow. That, in turn, lets the borrower sell the property or refinance it without tripping the loan’s restrictive covenants.
How the Collateral Swap Works
The core of the transaction is buying a portfolio of U.S. government securities whose payment schedule mirrors the remaining loan payments exactly. These are typically non-callable Treasury notes and bonds, chosen because their payment dates and amounts can be precisely matched to the loan’s amortization schedule.
The technical term for this precision is cash flow matching. Every scheduled principal and interest payment on the original loan must be covered by a corresponding payment from the securities portfolio on a date-by-date basis. There’s no room for approximation. If the loan calls for a $47,312.50 payment on the fifteenth of a given month, the portfolio has to produce that exact amount on that exact date.
A defeasance consultant structures the portfolio, selecting the right combination of security maturities and coupon rates to hit the match. Once purchased, the securities move to a collateral agent, usually an institutional trust company, which holds the portfolio and remits payments to the loan servicer on schedule. The lien on the original property is released only after this transfer is complete and verified. At no point is the CMBS loan unsecured.
What Happens to the Loan Itself
When defeasance closes, the original borrower doesn’t keep the loan. A special purpose entity steps in as the successor borrower, taking ownership of the defeasance collateral and legal responsibility for the loan going forward. That SPE has to be acceptable to the rating agencies that oversee the CMBS trust.
Who controls the successor entity matters more than most borrowers realize at origination. Ideally, you negotiate the right to designate the successor borrower in the original loan documents. If that right isn’t preserved, the originating lender can sell it to a third party, who will then charge a fee to participate in your defeasance and keep any residual value the portfolio produces.
Residual value comes from two sources. First is float value, from small timing gaps between when the securities pay out and when the loan payments are due. Second, if the loan has an early open prepayment date and gets paid off before maturity, the remaining securities can be sold on the open market. Both flow to whoever controls the successor borrower, and on larger loans the residual can reach six figures.
What Defeasance Costs
The purchase price of the securities portfolio is by far the largest expense, and it’s driven almost entirely by the relationship between your loan’s interest rate and current Treasury yields.
When Treasury yields sit below your loan rate, defeasance gets expensive. Lower-yielding securities produce less income per dollar invested, so you have to buy more of them to generate cash flows matching your higher-rate payments. The portfolio ends up costing significantly more than your outstanding principal, and that premium comes out of your pocket.
When rates rise above your loan rate, the math flips. Higher-yielding securities cost less to produce the same cash flows, and the portfolio price can drop below the outstanding loan balance. In a rising-rate environment, defeasance costs have in some cases come in below the remaining principal, effectively creating a discount for the borrower.
On top of the securities themselves, professional fees generally run between $50,000 and $100,000. The main line items are the defeasance consultant, legal counsel experienced in CMBS transactions, an accountant, a securities broker-dealer, the loan servicer’s own processing fee, and a custodian to hold the portfolio for the remaining term. These costs are largely fixed regardless of loan size, so defeasance is proportionally much more expensive on smaller loans. On a $2 million loan, $75,000 in fees is nearly 4% of the balance. On a $20 million loan, it’s less than half a percent.
How the Process Runs
Defeasance typically takes about 30 days from start to close. It begins with formal notice to the loan servicer, which most loan documents require at least 30 days before the closing date. The servicer responds with an official defeasance quote and a checklist of required closing items.
The borrower then assembles a deal team: defeasance consultant, CMBS legal counsel, and an accountant. The consultant calculates the cost and composition of the required securities portfolio based on current market conditions. Counsel coordinates the documentation the servicer and rating agencies require, including a non-consolidation opinion confirming that the successor borrower SPE is sufficiently separate from the original borrower that a bankruptcy court would not combine their assets and liabilities.
At closing, several things happen simultaneously. The purchased securities transfer to the collateral agent, the successor SPE formally assumes the loan, and the lien on the original property is released. The original borrower walks away with a free-and-clear property and no further obligation on the defeased debt.
Defeasance vs. Yield Maintenance
The other common exit route from a CMBS loan after the lockout period is yield maintenance, and it’s worth understanding the distinction because your loan documents will specify which options are available. Some loans offer only one.
Defeasance is a process. You replace the property collateral with government securities, a successor entity takes over the loan, and the debt continues running until maturity. Multiple parties are involved, and the transaction costs are substantial.
Yield maintenance is just math. You calculate a lump-sum penalty based on the difference between your loan’s interest rate and current Treasury yields for the remaining term, then pay it at closing. The loan ends. There’s no successor borrower, no collateral swap, and no ongoing obligation. Many lenders still require 30 days’ notice, but the process is simpler and faster.
Penalty amounts for both options tend to land in a similar range, but the variables are different. Yield maintenance costs are driven by the rate differential and sometimes include an adjustment of 0.50% to 0.75%. Defeasance costs depend on the shape of the yield curve and the availability of higher-yielding agency securities for the replacement portfolio.
Tax and Balance Sheet Consequences
The tax and accounting treatment of a defeased loan turns on whether the transaction qualifies as a legal defeasance or an in-substance defeasance, and the distinction has real dollar implications.
In a legal defeasance, the borrower is fully released from liability. If the securities portfolio costs less than the outstanding loan balance, the difference is treated as liability relief and becomes part of the amount realized on the property disposition. If the portfolio costs more, the premium reduces the seller’s amount realized as a transaction cost.
Most CMBS defeasances are in-substance rather than legal. The borrower technically remains liable for the debt even though the securities portfolio will cover every payment. There’s no immediate tax recognition at the time of defeasance, and the premium can’t be deducted at closing. The borrower is also treated as owning the substitute collateral for tax purposes, since any excess income or principal flows back to the successor borrower entity.
The accounting rules are stricter than many borrowers expect. Under ASC 405-20, a debtor can remove a liability from the balance sheet only when the creditor has legally released the debtor from the obligation.1Deloitte Accounting Research Tool. Deloitte’s Roadmap: Issuer’s Accounting for Debt – 9.2 Extinguishment Conditions Legal defeasance meets that test; in-substance defeasance does not, and the debt stays on your books even though you’ve fully funded its repayment and walked away from the property.2PwC. 3.8 Debt Defeasance That’s another reason successor borrower control matters: if you control the SPE, your path to achieving a legal defeasance and the cleaner balance sheet that comes with it is much easier.3Chatham Financial. Defeasance Best Practices for Borrowers, Brokers, Counsel Without it, you may be reporting both the debt and the defeasance collateral until maturity, which can complicate later financing or corporate transactions that depend on clean leverage ratios.