Picture it: The commercial property you bought two years ago has exploded in value. The deal of a lifetime is on the table—an offer that could fund your next three investments. That nest egg is tantalizingly close, but it’s all being held up by a single, intimidating word you found in your loan documents: defeasance.
You feel trapped by your own success, locked into a loan with years left on the clock. You can’t just pay it off. Don’t panic. This isn’t a trap it’s a key. In this guide, we’ll unlock the concept of defeasance, show you exactly how it works, and explain how to use it to your advantage as a real estate investor.
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How Defeasance Actually Works: The “Robot House Sitter” Analogy
To understand defeasance, think of your commercial loan as a promise. You promised your lender a steady stream of income (your mortgage payments) for 10 years. For many commercial lenders, especially those who package loans to sell to bond investors (like in a CMBS loan), that guaranteed income stream is sacred.
Defeasance is their preferred method for letting you out of the deal because it keeps their income promise intact. It’s like hiring a government-backed ‘robot house sitter’ to take over for you.
Here’s the process:
- You Swap Your Property for Bonds: You use money from your sale to buy a portfolio of ultra-safe government securities (like U.S. Treasuries).
- The Bonds Take Over Payments: This bond portfolio is perfectly structured to make your exact mortgage payments to the lender for the rest of the term.
- Your Property is Freed: The lender accepThe lender accepts this new, ultra-safe collateral. Your property is released from the loan’s lien, free and clear for you to sell or refinance.
So, When Would I Actually Use This?
Now that you see how it works, let’s talk about why you’d use it. Defeasance is your tool for unlocking opportunity.
1. Cashing In on a Red-Hot Market
You have an incredible offer to sell your property at a massive profit, but your loan has a “lockout period” preventing an early payoff. Defeasance provides the mechanism to satisfy the lender, complete the sale, and realize your gains. Learn more about lockout periods and defeasance.
2. Slashing Your Interest Rate (or Cashing Out Equity)
Interest rates have fallen, and you want to refinance to a lower rate. Or, you need to pull out capital for your next investment. Defeasance is often the only way to exit the old, restrictive loan so you can secure a new one through portfolio loan options or traditional financing.
The Big Question: What Does This Really Cost?
This is the most critical part. The power of defeasance comes at a price, and it’s your job as an investor to understand it.
The Interest Rate Gap Explained
The cost comes down to one simple concept: you have to make the lender “whole.” The cost to do that depends entirely on the interest rate gap between your loan and current government bond yields.
- Scenario 1: Rates Have FALLEN (This is the expensive one).
- Your Loan Rate: 5%
- Current Bond Yields: 3%
- The Problem: You have to buy a portfolio of bonds that pays your lender 5% interest, but the bonds available today only yield 3%. To make up that 2% difference, you have to buy a larger dollar amount of bonds. That extra cash you have to put in—the premium to bridge the gap—is the primary cost of your defeasance. This can easily run into the tens or hundreds of thousands of dollars.
- Scenario 2: Rates Have RISEN (This is cheaper for you).
- Your Loan Rate: 5%
- Current Bond Yields: 7%
- The Opportunity: Now, it takes fewer dollars to buy a portfolio of bonds that can pay the lender their 5% interest, because the bonds are yielding more. In this scenario, the core cost of defeasance is very low, and you might even get a small credit. However, you still have to pay the other fees.
Don’t Forget the Other Fees
This is a complex transaction and is not a DIY project. You must budget for:
- Defeasance Consultant Fees: This is a non-negotiable expert who will structure the bond portfolio and manage the entire process.
- Accountant and Legal Fees: For reviewing all documents.
- Loan Servicer Processing Fees: For handling the transaction.
Defeasance vs. Yield Maintenance: What’s the Difference?
You might see another term: Yield Maintenance. They are both prepayment options but are fundamentally different.
| Metric | Defeasance | Yield Maintenance |
| What is it? | A collateral substitution process. | A cash penalty payment. |
| What happens to the loan? | The loan stays open, backed by bonds. | The loan is paid off and closed. |
While the formulas are different, the lender’s goal is the same: to be compensated for the interest payments they’ll miss out on. Your loan agreement will specify which method you have to use.
FAQs: Defeasance in Real Estate
Is defeasance the same as a prepayment penalty?
No, defeasance is not the same as a prepayment penalty. A prepayment penalty is a cash fee for paying off a loan early. Defeasance, on the other hand, is a collateral substitution where your loan technically stays open, but government bonds take over the payments. This makes defeasance a more structured and lender-friendly solution.
What type of loan typically has a defeasance clause?
It is most common in commercial loans, particularly CMBS (Commercial Mortgage-Backed Securities) or “conduit” loans. You might also encounter it in jumbo loans and certain construction loans.
What does defeasance mean in simple terms?
It means replacing your property as the loan’s collateral with a portfolio of government bonds that makes the same payments to the lender, freeing your property from the loan.
Conclusion: Your Path from Beginner to Savvy Investor
Understanding a term like defeasance means you’re no longer just getting started you’re learning the rules of the game. It’s not a scary monster in your loan documents it’s the “Robot House Sitter” you can hire to unlock your next big opportunity.
