Introduction:
Defeasance is a method used by commercial real estate borrowers to reduce the fees associated with prepaying a fixed-rate loan.
This option allows borrowers to exchange another cash-flowing asset, typically Treasury securities, for the original collateral on the loan.
By doing so, borrowers can potentially benefit from financial gains when interest rates rise, while lenders receive the same cash flow with a better risk-adjusted investment.
Key Takeaways:
- Defeasance allows borrowers to reduce prepayment fees by exchanging a cash-flowing asset for collateral on a fixed-rate commercial real estate loan.
- Borrowers can benefit from defeasance when interest rates rise above the loan rate, creating value and putting cash in their pockets at prepayment.
- Defeasance reduces the overall risk of the lender’s investment and increases the value of mortgage-backed securities.
How it Works:
When borrowers choose to defease their fixed-rate commercial real estate loan, they replace the collateral with assets that provide the same cash flows as the original loan.
Typically, Treasury bonds with maturities equal to the remaining loan term are purchased and assigned to a defeasance trust. This trust passes the cash flows to the lender until the bonds mature.
Key Components:
- New Collateral: The new collateral, often Treasury securities, is less risky than the original commercial real estate assets, reducing the lender’s risk and increasing the value of mortgage-backed securities.
- Rising Interest Rates: Defeasance benefits borrowers when interest rates rise above the loan rate, allowing them to purchase required bonds for less than the loan balance and putting cash in their pockets at prepayment.
- Financial Advantages: Defeasance provides advantages over yield maintenance or long-term, variable-rate financing by creating value for borrowers and preserving the possibility of creating value with financing.
Benefits:
- Reduced Prepayment Fees: Defeasance allows borrowers to minimize the fees associated with prepaying a fixed-rate loan, providing potential financial gains.
- Risk Reduction: By exchanging the collateral with less risky assets, lenders benefit from a better risk-adjusted investment and increased value of mortgage-backed securities.
- Increase in Financing Options: Borrowers have the flexibility to choose fixed-rate financing with the defeasance option, which can be more attractive than short-term, variable-rate financing.
Takeaway:
Defeasance is a valuable method for commercial real estate borrowers to reduce prepayment fees and potentially generate financial gains.
By replacing the collateral on a fixed-rate loan with less risky assets, both borrowers and lenders benefit from a better risk-adjusted investment.
However, borrowers should carefully consider their prepayment options and work with professionals experienced in defeasance transactions to make informed asset management decisions.
Disclaimer: The information on this website, including glossary definitions, is for educational and informational purposes only and not intended as professional advice. While we strive for accuracy, we make no guarantees regarding the completeness, reliability, or timeliness of the information provided. We are not liable for any loss or damage arising from your use of the site. Investment decisions in commercial real estate should be made based on individual due diligence and professional advice. Laws and regulations are subject to change; always consult legal and financial experts before making decisions.
Sources:
https://www.investopedia.com/articles/mortgages-real-estate/08/defeasance.asp
