How to Calculate Defeasance

In the world of commercial real estate finance, "defeasance" is a term that often strikes fear into the hearts of borrowers looking to sell or refinance. Unlike a standard prepayment penalty, defeasance is a complex legal and financial process that involves substituting collateral. If you are dealing with a CMBS (Commercial Mortgage-Backed Securities) loan, understanding how to calculate these costs is vital for your exit strategy.

What is Defeasance?

Defeasance is the process of replacing the real estate collateral of a loan with a portfolio of government securities (typically US Treasuries). These securities are structured to provide a cash flow that exactly matches the remaining debt service (interest and principal) of the loan through its maturity date.

Because the lender is guaranteed to receive their payments from the risk-free Treasuries, they release the lien on the property, allowing the owner to sell or refinance.

The Core Components of the Calculation

To calculate defeasance accurately, you must look at three primary factors:

• The Cost of the Securities: This is the most significant component. If your loan interest rate is higher than the current Treasury yields, the portfolio will cost more than your remaining principal balance.
• The Yield Spread: The difference between your loan's coupon rate and the yield of the replacement securities. A wider spread (where loan rates are much higher than Treasuries) results in a higher "premium."
• Transaction Costs: You aren't just buying bonds. You must pay for a "successor borrower" entity, legal counsel for the lender, your own legal counsel, an accountant to verify the cash flows, and a securities intermediary. These fees typically range from $40,000 to $60,000.

Step-by-Step Calculation Process

Step 1: Determine Remaining Debt Service

Identify every remaining payment you owe until the loan's maturity or open period. This includes monthly interest, scheduled principal amortization, and the final balloon payment.

Step 2: Calculate the Cost of Treasuries

You must purchase a "laddered" portfolio of US Treasury strips or bonds. The cost of this portfolio is essentially the Net Present Value (NPV) of your remaining debt service, discounted at the current market yield of those Treasuries. If Treasury rates have fallen since you took out your loan, the NPV will be significantly higher than your current principal balance.

Step 3: Factor in the Defeasance Premium

The premium is the difference between the cost of the securities and your remaining principal. If your loan is at 5% and Treasuries are at 2%, you are effectively paying the lender the 3% difference they would have earned over the remaining life of the loan.

Step 4: Add Professional Fees

As mentioned, the "soft costs" of defeasance are substantial. Unlike yield maintenance, which is often a simple formula, defeasance requires a team of professionals to execute, and their fees must be added to the total cost.

Yield Maintenance vs. Defeasance

While both are prepayment penalties, they function differently. Yield maintenance is a penalty payment made directly to the lender. Defeasance is a collateral substitution. Generally, if Treasury yields are very low compared to your loan rate, defeasance becomes much more expensive. However, because it involves buying actual bonds, the cost fluctuates daily with the bond market.

Conclusion

Calculating defeasance is not just about looking at a balance sheet; it's about timing the bond market. Before you commit to a sale or refinance, use the calculator above to get a baseline estimate, and always consult with a professional defeasance consultant to get a real-time quote based on current Treasury "strips."