What is Defeasance in Real Estate?

Defeasance is a term that is commonly used in real estate to refer to the process of releasing a property from a mortgage obligation. In simple terms, it is a way for property owners to terminate their existing mortgage agreement by substituting it with a portfolio of government securities that will produce the same cash flow as the mortgage. This process is often used by commercial property owners who want to sell their property before the end of the mortgage term, but do not want to pay the prepayment penalty. Defeasance can be a complicated process, but it can save property owners a significant amount of money in the long run.

In this article, we will take a closer look at what defeasance is in real estate, how it works, and why property owners should consider it as an option. We will also discuss the advantages and disadvantages of defeasance, as well as the steps involved in the process. By the end of this article, you should have a better understanding of defeasance and how it can benefit you as a property owner.

How Does Defeasance Work?

When a property owner wants to defease their mortgage, they must first identify a portfolio of government securities that will produce the same cash flow as the mortgage. This portfolio, known as the defeasance collateral, is typically made up of U.S. Treasuries or other government-backed securities. Once the collateral has been identified, the property owner will purchase it and place it in a trust, which is managed by a third-party custodian.

Next, the property owner will enter into a new agreement with the mortgage lender, known as the defeasance agreement. This agreement will outline the terms and conditions of the defeasance process, including the amount of the collateral, the interest rate, and the maturity date. The defeasance agreement will also include provisions for the payment of the prepayment penalty, if applicable.

Once the defeasance agreement has been signed, the property owner will make monthly payments to the trust, which will use the cash flow generated by the collateral to pay off the mortgage. The trust will continue to make payments until the mortgage has been fully paid off. At that point, the property owner will have successfully defeased their mortgage and will own the property free and clear.

Advantages of Defeasance

There are several advantages to defeasance that make it an attractive option for commercial property owners. These include:

  • Lower prepayment penalties: By substituting the mortgage with a portfolio of government securities, property owners can avoid paying the often high prepayment penalties that are associated with traditional mortgage agreements.
  • Greater flexibility: Defeasance allows property owners to sell their property before the end of the mortgage term without having to pay the prepayment penalty. This can be especially beneficial if the property has appreciated in value and the owner wants to cash out their investment.
  • Preserves cash flow: By using the cash flow generated by the collateral to pay off the mortgage, property owners can preserve their cash flow and avoid having to come up with large lump sum payments.
  • Lower interest rates: In many cases, the interest rates on government securities are lower than those on traditional mortgages, which can result in significant savings over the life of the loan.

Disadvantages of Defeasance

While there are many advantages to defeasance, there are also some potential drawbacks that property owners should be aware of. These include:

  • Higher transaction costs: Defeasance can be a complicated process that involves many different parties, including the property owner, the mortgage lender, the third-party custodian, and the attorneys involved in the transaction. As a result, the transaction costs associated with defeasance can be higher than those associated with traditional mortgage agreements.
  • Lower liquidity: While government securities are generally considered to be safe investments, they may not be as liquid as other types of investments. This can make it more difficult for property owners to access their cash if they need it in the short term.
  • Market risk: The value of government securities can fluctuate depending on market conditions, which can affect the cash flow generated by the collateral. This can result in a shortfall in the amount needed to pay off the mortgage, which could lead to default if the property owner is unable to make up the difference.

The Defeasance Process

The defeasance process can be a complicated one, involving many different parties and legal documents. The following is a brief overview of the steps involved:

  1. Identify the collateral: The first step in the defeasance process is to identify a portfolio of government securities that will produce the same cash flow as the mortgage.
  2. Purchase the collateral: Once the collateral has been identified, the property owner will purchase it and place it in a trust, which is managed by a third-party custodian.
  3. Execute the defeasance agreement: The property owner will then enter into a new agreement with the mortgage lender, known as the defeasance agreement.
  4. Make monthly payments: The property owner will make monthly payments to the trust, which will use the cash flow generated by the collateral to pay off the mortgage.
  5. Release the mortgage: Once the mortgage has been fully paid off, the property owner will release the mortgage and own the property free and clear.

Conclusion

Defeasance is a valuable tool that can help commercial property owners save money and gain flexibility when it comes to their mortgages. By substituting their mortgage with a portfolio of government securities, property owners can avoid prepayment penalties, preserve cash flow, and benefit from lower interest rates. However, defeasance can be a complicated process that involves many different parties and legal documents, and there are potential drawbacks to consider, such as higher transaction costs and market risk. As with any real estate transaction, it is important to consult with a qualified attorney or financial advisor before pursuing defeasance.

People also ask

What is a defeasance clause in a mortgage?

A defeasance clause in a mortgage is a provision that allows the borrower to substitute a portfolio of government securities for the mortgage in order to satisfy the mortgage obligation. This clause is typically included in commercial mortgage agreements and is designed to give the borrower more flexibility when it comes to selling the property before the end of the mortgage term.

What is the difference between defeasance and prepayment?

Defeasance and prepayment are two different ways for property owners to terminate their mortgage agreement. Defeasance involves substituting the mortgage with a portfolio of government securities, while prepayment involves paying off the mortgage early. Prepayment is generally subject to a penalty, while defeasance allows property owners to avoid or minimize the prepayment penalty.

What is the cost of defeasance?

The cost of defeasance can vary depending on a number of factors, including the size of the mortgage, the interest rate, and the amount of the prepayment penalty. In general, defeasance can be more expensive than prepayment, due to the higher transaction costs associated with the process. However, the cost of defeasance can be offset by the savings in prepayment penalties and lower interest rates.

How long does the defeasance process take?

The defeasance process can take several weeks to several months to complete, depending on the complexity of the transaction and the number of parties involved. During this time, the property owner will be required to make monthly payments to the trust in order to pay off the mortgage. It is important to work with a qualified attorney or financial advisor to ensure that the defeasance process is completed in a timely and efficient manner.

Related video of What is Defeasance in Real Estate?