Defeasance

Defeasance — Definition and Overview

Defeasance is a financial strategy that lets a borrower effectively nullify a loan or bond obligation by setting aside sufficient funds—typically cash and high-quality securities—to cover remaining payments. When properly structured and legally executed, the debt obligation is treated as satisfied even though the borrower may not have paid the lender directly. Defeasance is commonly used in commercial real estate finance to avoid prepayment penalties while ensuring investors continue to receive expected cash flows.

Key takeaways

• Defeasance substitutes a portfolio of cash and securities for an outstanding loan or bond, allowing the borrower to remove the debt from its balance sheet.
• It’s frequently used in commercial mortgage-backed securities (CMBS) transactions to avoid prepayment penalties that would harm bondholders’ expected returns.
• Setting up defeasance typically requires legal, tax and financial expertise and involves transaction costs and ongoing administrative steps.
• A defeasance clause in loan documents defines the conditions under which title or deed is released once obligations are met.

How defeasance works

1. The borrower or buyer assembles a portfolio of cash and/or government-grade/semi-government bonds whose future payments (principal and interest) match the remaining scheduled payments on the loan.
2. Those assets are placed in a defeasance account or escrow under the control of a trustee or third party.
3. The receivables from the defeasance portfolio are dedicated to paying the original loan’s scheduled interest and principal to the bondholders or lenders.
4. Because the loan’s future payments are effectively secured by the defeasance portfolio, the borrower’s legal obligation to the lender is extinguished and the borrower can obtain title or otherwise exit the loan without triggering prepayment penalties.

Commercial real estate example

Commercial mortgages often sit inside CMBS structures where investors expect a set stream of interest payments. If a borrower prepays, those expected payments disappear and bondholders lose anticipated income. To avoid prepayment penalties, a commercial property buyer can purchase a portfolio of high-quality bonds that replicates the mortgage’s remaining cash flows. Bondholders continue to receive the same payments, while the borrower gains the economic effect of paying off the loan and can secure title to the property.

Steps to create a defeasance account

• Engage legal and financial advisors experienced in defeasance and CMBS transactions.
• Determine the exact remaining payment schedule and required cash flows.
• Select and purchase securities whose coupons and maturities match the schedule (liability matching).
• Place the securities and any required cash into a defeasance account or trust under a neutral trustee.
• Complete legal documentation to transfer the lender’s interest and obtain release of collateral or title.
• Monitor and administer the defeasance account until the obligations are fully satisfied.

Navigating defeasance clauses

A defeasance clause in a mortgage or loan agreement permits the borrower to obtain title or a full release of collateral once the defeasance conditions are met. Similar mechanisms appear in other financed purchases (for example, vehicle loans) where the lender’s security interest is released after repayment or equivalent arrangements.

Accounting and balance-sheet impact

When defeasance is completed and the borrower has legally transferred sufficient assets to satisfy the obligation, the loan may be removed from the borrower’s balance sheet because the legal liability has been extinguished. The borrower, however, will typically have restricted assets held in the defeasance account. Accounting treatment can vary depending on jurisdiction and specific transaction terms, so professional accounting advice is important.

Pros and cons

Pros:
* Enables early exit from loans without triggering prepayment penalties.
* Maintains investor cash flows and market stability in securitized structures.
* Can improve borrower flexibility and access to property title.

Cons:
* Transaction is complex and can be costly (legal, trustee, and transaction fees).
* Requires precise cash-flow matching and ongoing administration.
* Limits borrower flexibility over the assets placed in the defeasance account.

Bottom line

Defeasance is a specialized tool for extinguishing debt obligations by replacing the borrower’s liability with a dedicated portfolio of cash and securities. It is especially useful in commercial real estate finance to avoid prepayment penalties in securitized loans, but it requires careful structuring, legal documentation, and professional advice to execute effectively.