Commercial real estate investors who favor fixed-rate debt financing occasionally find themselves having to pay prepayment penalties when they settle their debt in advance of the maturity dates of their loans. Of the different prepayment options, defeasance is one that provides the greatest flexibility and potential financial gains when market interest rates rise. Read on to learn more about how defeasance can provide straightforward solutions in complex lending scenarios. (For background reading, see Find Fortune In Commercial Real Estate.)

What's Defeasance?
Defeasance, as its name suggests, is a method for reducing the fees required when a borrower decides to prepay a fixed-rate commercial real estate loan. Instead of paying cash to the lender, the defeasance option allows the borrower to exchange another cash flowing asset for the original collateral for the loan. 

The new collateral (normally Treasury securities) is usually much less risky than the original commercial real estate assets. In this scenario, the lender is far better off because it receives the same cash flow and in return receives a much better, risk-adjusted investment. Although the benefit of defeasance for the lender is obvious, borrowers can also benefit significantly. If interest rates on loans rise to a rate greater than those of the mortgage, borrowers can create value and put cash in their pockets at prepayment. Because defeasance is an option offered during the negotiation of a commercial real estate loan, borrowers should consider it in order to preserve the possibility of creating value with their financing.

Rationale for Defeasance 
Variable-rate commercial real estate loans are an appropriate method of financing short-term needs such as construction or bridge financing, which is capital loaned to real estate owners in the lease-up phase; it is repaid when the property eventually has cash flow. 

Although the interest rate risk is high and there is no limit to the financial downside, some borrowers will take on long-term, variable-rate financing. This often happens when there is a high probability that a property with cash flow will be sold before the loan matures.

Borrowers use variable-rate financing for many reasons. One significant reason is to circumvent the prepayment penalties that lenders require when prepaying fixed-rate debt. On variable-rate financing, lenders do not incur reinvestment risk because the loan rates "float" with the market and, when repaid, can then be lent again at the same market rates. (To learn more about these loan structures, see Mortgages: Fixed-Rate Versus Adjustable-Rate.)

Risks for Lenders
Fixed-rate financing has the potential for creating financial losses or the reduction of a lender's yield when capital is repaid and then lent out at lower market rates. Due to the potential for reinvestment risk, lenders usually require some sort of prepayment penalty from those who borrow fixed-rate debt. Originally, lenders required "yield maintenance", which dictated that borrowers pay the rate differential (between the loan rate and the prevailing market rate) on the prepaid capital for the period remaining to loan maturity. Because there is opportunity and financial cost associated with originating new mortgage assets, defeasance was designed as a way to eliminate reinvestment risk and the need to relend prepaid capital.

Defeasance allows borrowers to replace the collateral of their loans with assets that provide the same cash flows as the original loan. This asset exchange allows lenders to continue to receive their expected yield throughout the loan term without having to find new lending opportunities to replace the prepaid capital. As previously mentioned, the exchange of a less risky asset (U.S. Treasuries in the place of a commercial real estate property) reduces the overall risk of the lender's investment. This is an even greater benefit for institutions that securitize these mortgages. By elevating the probability that the investors will receive all the contracted payments of interest and principal, defeasance greatly increases the value of mortgage-backed securities and profits for the lenders. (For background reading, see What is securitization?)

Benefits and Issues for Borrowers
Defeasance unlike, yield maintenance, offers upside potential for borrowers when market rates rise above the contracted loan rate. Yield maintenance is referred to as a penalty because borrowers are subject to some type of payment regardless of which direction market rates move. It is usually structured as the greater of the yield maintenance calculation or a percentage of the amount prepaid. Because defeasance requires the purchase of Treasury bonds, the movement of rates directly impacts the costs of these assets and impacts whether defeasance will be a cost or a windfall at prepayment.

In most cases, defeasance involves the purchase of Treasury bonds with maturities equal to the remaining term of the loan, with coupon rates that provide the necessary income to offset the contracted periodic interest and principal payments. These bonds are then assigned to a defeasance trust that passes the periodic cash flows to the lender until the bonds mature. Depending on the difference between the rates of the bonds necessary to defease the loans and market rates, the Treasury bonds will trade for a discount or a premium.

When rates rise, Treasury bonds (or any fixed-income investment) lose value and become cheaper. When this happens, borrowers are able to purchase the required bonds for less than what is required to prepay the loan, resulting in additional cash in their pockets. In the reverse situation, when rates fall, fixed-income investments become more expensive. This requires the borrower to pay an amount greater than the loan balance at prepayment. On the downside, the yield maintenance calculation will result in the exact same amount of additional capital necessary to defease the loan. This does not take into consideration any transaction costs that would be incurred to purchase the bonds necessary to defease the loan. These costs vary depending on the bid-ask spread or the forces of supply and demand for the bonds. On the upside, defeasance is beneficial while yield maintenance will still require some penalty to be paid.

The defeasance option provides fixed-rate borrowers with advantages over those who choose yield maintenance or long-term, variable-rate financing. It is a good tactical decision for borrowers who feel that they have the skill to predict interest rate movements. It is also a good choice for real estate investors who know that they will be required to sell their properties in the short term, but are worried about the potential increases in debt service if they choose to use variable rate debt. Borrowers using portfolio level debt (one loan that is collateralized by multiple commercial properties) find that lenders will sometimes require borrowers to repay a greater percentage of a loan than an asset's value contribution to the portfolio. This situation results when the lender believes that a borrower is selling an asset that is less risky than the remaining assets in the portfolio. Because the portfolio becomes riskier with the reduction of the less risky asset, lenders will require a prepayment amount that will compensate them for the greater risk being borne, effectively deleveraging the remaining portfolio and reducing the investor's leveraged return.

Because defeasance results in the exchange of a less risky asset than the collateral, borrowers can keep the same percentage of debt in the portfolio after the sale of an asset. With the agreement of the lender it may be possible to increase the percentage of debt on the remaining assets when the defeasance is executed.

Another benefit to borrowers is that lenders don't usually require any type of payment, either upfront or by increasing loan rates, in order to receive the defeasance option. If rates rise, there is value creation potential for the borrower; therefore, it is conceivable that lenders could ask for compensation for selling the option. 

Conclusion
Borrowers need to be aware of their prepayment options so that they make the correct asset management decisions. For example, in periods of significant interest rate increases it may be preferable to sell a suboptimal commercial asset because of the value created by defeasing the loan. On the downside, it may make sense to hold on to an asset even after value optimization. The time left on the loan at prepayment directly influences the prepayment costs. All things being equal, prepayment penalties dissipate over time.

When negotiating loan terms of a commercial real estate loan, borrowers should ask for the ability to defease their fixed-rate loans even if they have no intention of prepaying the obligation before maturity. The distinct advantage that defeasance provides over other prepayment options is significant due to its ability to create an income-generating event when market interest rates rise. It is conceivable that during periods of rising interest rates, real estate owners that prefer fixed-rate financing can produce capital gains on their debt obligations that can more than offset the decreases in real estate values. Real estate investors that use of financial leverage to purchase real estate investment opportunities that are to be fixed then sold should consider fixed-rate financing with the defeasance option as an attractive alternative over short-term, variable rate financing.