What Is a Defeasance Fee and How Is It Calculated?
Learn how a defeasance lets commercial borrowers exit loans early by replacing the debt with a securities portfolio, a process driven by interest rate spreads.
A defeasance fee is a prepayment provision in certain commercial loans, particularly those in Commercial Mortgage-Backed Securities (CMBS). It allows a borrower to release their property from the mortgage lien before the loan’s maturity date. This is done by providing the lender with a new income stream that replaces the original loan payments, ensuring investors receive their expected return.
This mechanism works by substituting the real estate collateral with a secure portfolio of assets, usually U.S. government securities. This substitution guarantees the lender and investors are made whole from the early prepayment. The process allows the borrower to regain control of their property for a sale or refinance while upholding the original terms of the investment.
The Defeasance Calculation Explained
The defeasance cost is primarily the amount needed to buy a portfolio of securities that will generate the exact principal and interest payments remaining on the loan. The most significant factor driving this cost is the interest rate spread. This is the difference between the interest rate on the borrower’s loan and the current market yield on the government securities that must be purchased.
If the loan has a higher interest rate than the yields on available Treasury securities, the borrower must pay a premium to acquire a portfolio large enough to cover the loan payments. This difference between the cost of the securities and the remaining loan balance makes up most of the defeasance fee. For example, if a loan has a 5% interest rate, but government securities yield only 3%, the borrower must spend more than their outstanding loan balance to generate the required return for the lender.
The remaining term of the loan also plays a role in the calculation. A loan with a longer remaining term is more exposed to interest rate fluctuations. A small change in the interest rate spread has a much larger financial impact on a loan with ten years remaining compared to one with only two years left, as the portfolio must cover more payments.
Information and Costs for a Defeasanse Transaction
Before initiating a defeasance, a borrower must gather the original loan agreement, the promissory note, and the mortgage or deed of trust. These documents contain the specific defeasance clause outlining the rules for the transaction. A current loan amortization schedule is also necessary to determine the remaining payments the securities portfolio must replicate.
The total expense of a defeasance goes beyond the cost of the securities. Borrowers must account for third-party fees that can total between $50,000 and $70,000 or more. These fees include:
- A defeasance consultant’s fee, which can be around $7,500.
- The loan servicer’s processing fee, which can range from $5,000 to $40,000.
- The lender’s counsel fees, paid by the borrower, which range from $15,000 to $25,000.
- Fees for the borrower’s own attorney.
- Counsel fees for the “successor borrower,” which can be between $4,000 and $10,000.
- Rating agency review fees, which can add up to $25,000 if the loan is in a CMBS pool.
The Step-by-Step Defeasance Process
The first step is to engage a defeasance consultant to act as a project manager, coordinating with attorneys, accountants, the loan servicer, and securities brokers. The process typically takes 30 to 45 days from start to finish. The borrower, through their consultant, must formally notify the loan servicer of their intent to defease the loan, often 30 to 60 days before the planned closing.
The servicer and its legal counsel will then provide a checklist of required items and begin drafting the necessary legal documents. The consultant works with the servicer to generate a final, locked-in defeasance quote based on the current market price of the required securities. A key part of the transaction is creating a new, independent entity known as a “successor borrower.”
This special purpose entity is formed to assume the original loan obligation, allowing the original borrower to be fully released from the debt. The consultant facilitates the purchase of the government securities portfolio on the open market. The process concludes at the closing, where funds from the property sale or refinance are used to purchase the securities. The securities are then transferred to the successor borrower as the new collateral, and the lender releases the lien on the original borrower’s real estate.
Tax Treatment of Defeasance Expenses
The tax treatment of defeasance costs depends on whether the transaction is part of a property sale or a refinance. The Internal Revenue Service (IRS) has not issued direct guidance for every defeasance scenario, so taxpayers should consult with a qualified tax professional for advice. The determining factor is whether the transaction results in a complete and legal release of the borrower from the original loan obligation.
If the borrower is fully released from the debt, the defeasance costs are generally deductible in the current year. When defeasance facilitates a property sale, the costs are treated as selling expenses, which reduce the taxable capital gain. If the defeasance is part of a refinance where the borrower is fully released, the costs may be deductible as an interest expense.
However, if the borrower retains any contingent liability for the loan, the debt may not be considered fully extinguished for tax purposes. In that case, the defeasance costs must be capitalized and amortized. This means the deduction is spread out over the term of the new loan in a refinancing or over the remaining term of the original loan.