A defeasance clause is a specialized provision primarily found in commercial real estate financing, especially within Commercial Mortgage-Backed Securities (CMBS) loans. It allows a borrower to replace the property’s collateral—usually the commercial building—with a portfolio of U.S. Treasury securities or similarly safe government bonds. This substitution releases the lien on the property without the borrower having to prepay or fully pay off the existing loan.
CMBS loans typically prohibit or heavily penalize early loan payoff to protect investors who purchased the loan-backed securities expecting consistent income. The defeasance clause helps borrowers sell or refinance their property without violating these terms or triggering costly prepayment penalties.
To utilize defeasance, the borrower buys a carefully structured portfolio of government securities designed by a defeasance consultant to match the loan’s remaining payment schedule exactly. These securities are pledged to the lender, often through a special-purpose vehicle (SPV), which then uses the securities’ interest and principal payments to service the original loan. Once this arrangement is approved, the lender removes the mortgage lien from the property, freeing it for sale or refinancing.
This process, while effective, is complex and can be costly. It involves purchasing securities that may exceed the outstanding loan balance due to yield differences, along with fees for legal, accounting, and professional specialist services. The timeline can span weeks to months.
Defeasance contrasts with a prepayment penalty: the former replaces collateral to maintain payment streams to investors without ending the loan, while the latter charges a fee to terminate the loan early. For a detailed overview of related concepts, see our Yield Maintenance article.
Because defeasance ensures uninterrupted payments to CMBS investors, it is a vital tool in commercial real estate finance but is rarely applied to residential mortgages, which generally allow simpler prepayment options.
For more on commercial financing context, also consider exploring Commercial Real Estate Loan and Commercial Real Estate Financing Models.
Authoritative IRS or government sources do not typically cover defeasance clauses directly, as this is a specialized commercial lending term, but detailed financial and real estate industry resources like the Commercial Real Estate Finance Council (CREFC) provide comprehensive explanations. This helps ensure investors’ interests and commercial borrowers’ flexibility align in complex loan structures.