THE BLOG
08/08/2013 12:45 pm ET Updated Oct 08, 2013

What Is Defeasance? How Does It Affect My Commercial Real Estate Loan?

The rules that govern home loans are not the same as the rules that govern commercial real estate loans. One of the major differences is that there is usually no penalty for early repayment of a home loan, whereas investors in commercial real estate can face stiff penalties for early repayment. You might be thinking, "Why woudn't my lender want to receive early payment on my commercial loan?" Early loan repayment is penalized when your loan has been securitized, meaning that your loan has been bundled with other loans and sold to bondholders as a debt security (in this case, a commercial mortgage-backed security [CMBS]). CMBS bondholders are expecting a certain rate of return on their security, and prepayment of your commercial loan will affect that rate of return.

Although you cannot repay a commercial real estate loan as simply as you can a home loan, it is still possible to repay a commercial loan early, through a complex process called defeasance. Because bondholders are expecting a certain rate of return from your commercial loan, you are prohibited from engaging in defeasance during the first two years after your loan's origination. However, after that two-year "lock-out period," you can repay the loan, in a sense, by substituting your commercial loan and its stipulated interest rate with a portfolio of high-quality bonds (usually U.S. Treasury bonds). The yield on the bonds will replace the interest rate from your commercial loan, and the CMBS bondholders will continue to receive their expected rate of return.

"Defeasance is a complex process," said Jack Rose, Chief Strategist at Breakwater Equity Partners. "It's a financial and legal transaction that has many moving parts. Every commercial real estate defeasance involves multiple parties with varying interests so it's important for you to have experts on your side." The majority of commercial real estate owners seek out professional help when they choose to refinance their CMBS loans prior to maturation. Defeasance usually requires a team of attorneys, banking experts, and financial professionals, who combine their expertise and skills so that you can refinance as quickly, smoothly, and as cost-effectively as possible.