Defeasance in Real Estate Finance: Process and Timing, Prepayment and Lockout Provisions

Description

Defeasance allows a borrower to prepay its existing loan after a specified lock-out period by substituting for the real estate collateral a basket of U.S. government-backed securities that generate cash flow sufficient to pay the ongoing debt service and the principal amount due at maturity. Defeasance thus results in yield protection for CMBS and other lenders that have been promised continued payments throughout the loan term.

The decision to refinance may be governed by the cost of defeasing the existing loan. Counsel must weigh the economic costs and benefits of defeasing a higher interest rate loan with lower yielding securities. Documentation is significant and typically includes the formation of a new SPE and transfer of the mortgage. Additional issues must be considered in states with significant mortgage taxes. If allowed, simple prepayment (with a prepayment penalty) might be the better option.

When involved in a refinance or sale that will require a defeasance to close, counsel must consider the transaction process and timing. All parties must agree to the closing timeline because once the borrower "pushes the defeasance button," the borrower must purchase securities and close the defeasance and the new loan within the allotted window or incur high breakage costs. In the CMBS context, servicer and rating agency approval must be obtained before closing.

Listen as our authoritative panel discusses the legal and economic complexities of defeasance.