ABOUT DEFEASANCE
WHAT IS DEFEASANCE?
Defeasance is the substitution of one type of collateral for another. In commercial real estate — specifically the Commercial Mortgage-Backed Securities (CMBS) industry — defeasance is the process of releasing a commercial property (the Original Collateral) from a mortgage and replacing it with a portfolio of securities (the Defeasance Collateral). Prior to defeasance, the property is the main income source for the borrower to pay its monthly loan payments.
Once a defeasance takes place, the securities portfolio effectively replaces the income stream of the property as it is structured to make the remaining principal and interest payments on the loan.
The borrower's loan obligations are transferred to a newly formed Successor Borrower entity. The original borrower is free to sell or refinance its property and is released from its mortgage.
Defeasance is effectively a prepayment for the original borrower, as it enables them to get out of their loan prior to maturity, but unlike a prepayment it keeps the loan payment stream intact.
HISTORY OF DEFEASANCE
Defeasance originally became a part of the CMBS market in the mid 1990s and was introduced as a way to create more favorable pricing on CMBS bonds and eliminate the prepayment risk that was associated with CMBS loans. Prior to the introduction of defeasance, Yield Maintenance was the main option for a borrower to prepay their securitized loan. Unlike defeasance, Yield Maintenance is a prepayment (or early termination) of a loan. It is less favorable for CMBS investors as they are interested in predictable and continuous cash flow and a yield maintenance prepayment causes a disruption in this cash flow.
Since 1998, the vast majority of securitized loans have included defeasance as the only option for a borrower to prepay their loan. For CMBS certificateholders, defeasance is a favorable mechanism since it maintains the payment stream they receive on a securitized mortgage, improves the credit quality of the collateral backing their certificates, and reduces their exposure to default risk.
Defeasance is an effective way to balance a borrower's need to obtain a release from their mortgage obligation (to enact a sale or refinance) with the certificateholders' need for predictable and uninterrupted cash flow.