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About Defeasance In Real Estate
When you take a mortgage on a property, whether it is a commercial or an investment property, the title and the rights of the property are with the lender until the mortgage is paid off.
As a borrower many would like to pay off the mortgage as soon as possible, however, there might be a pre-payment penalty if you try to pay it off early.
In such situations defeasance could be useful. In this post, we will understand what is a defeasance clause and how it works.
What Is Defeasance?
It is a legal process to release your commercial property from its debt obligation as collateral for a loan.
These accounts help the borrower to set aside funds to repay the debt and offset it in their balance sheet.
When you take a mortgage you present your property as collateral against the money that you borrow to purchase the commercial real estate property.
In most commercial mortgages, you won’t be able to pay off your mortgage before a specific time due to pre-payment penalties.
Your mortgage is sold in the secondary financial market in bundles along with other loans after you sign your loan agreement with the lender.
These loans are used to create investment instruments known as commercial mortgage-backed securities (CMBS).
If the borrower decides to pay the loan earlier than the matured date, the investors lose the opportunity to make profits with the interest amount that is charged on the loan.
Hence if the borrower wants to pay off early, they either need to bare the pre-payment penalty or use the defeasance clause.
How Does Defeasance Work?
Defeasance is used if the borrower needs to pay off the loan before its maturity. It allows the mortgage to be with the CMBS until it matures while the borrower holds the right and the title of the collateral.
It replaces your property as collateral with a government securities portfolio like US agencies and treasury bonds.
Money earned from this newly created portfolio is used to make monthly payments for the leftover months and the lump sum payment at the end of the loan maturity date.
The government securities that are defeased are considered less risky for the CMBS investors.
Once the defeasance clause is executed successfully, the collateral is released from the debt obligation and the borrower gets the right to own the property free to sell or refinance the property without paying any pre-payment penalty.
All this happens while your mortgage still lives on in the CMBS. Since the debt is replaced with another low-risk security, both the amounts offset each other in the borrower’s balance sheet.
What Are The Pros And Cons Of Creating Defeasance Accounts?
Pros:
- Since the cash flow from the government securities offset the associated debt, the borrower can remove the debt from the balance sheet making it less complex for accounting.
- By use of the defeasance clause, the borrower avoids paying the pre-payment penalties on the loan as the borrower replaces the collateral with the government securities portfolio and the loan still lives in the CMBS.
- The borrower has the complete right of the property as the defeasance clause will eliminate the lender’s right over the collateral.
Cons:
- There are many parties involved in a defeasance process like securities intermediaries, accountants, attorneys, title companies, etc. There is a cost involved to pay all the parties for their work. Hence, it would only make sense to use this clause if the pre-payment penalty is higher than the cost of creating a defeasance account.
- The borrower should have an exact or more amount in the government securities portfolio to replace the debt to free the collateral from the debt and remove it from the balance sheet.
Conclusion
Freeing the collateral from the debt is not an easy task even with or without defeasance. You need to ensure that you have enough funds to replace the value of your collateral with the securities for a successful defease.
Coordination will all the parties involved in a defeasance process is a job of a defeasance consultant. It is important to have consultants who reliably guide you and help you understand every step in the process.
