How defeasance works

A multifamily owner swaps the property that originally secured the loan for replacement collateral designed to yield enough cash flow to cover the remaining mortgage payments. The collateral often consists of fixed-rate government-backed bonds, giving the lender confidence the bonds will generate the required cash flow. 

The owner transfers the substitute collateral to an entity known as a successor borrower, which assumes the debt obligations so the original property can be released.   

Whether defeasance is an option depends on the borrower’s loan agreement. If defeasance is an option, the loan agreement will typically outline requirements, including: 

• The type of securities that can be purchased as collateral—for instance, whether the borrower can purchase securities from Fannie Mae and Freddie Mac as an alternative to U.S. Treasury securities
• The process for purchasing securities and whether the borrower can purchase them directly or must work with a third party
• The lock-out period during which defeasance is prohibited  

Successfully navigating the process can be complex. Defeasance consultants can help multifamily investors determine the cost of defeasance and execute the transaction correctly. 

Defeasance vs. yield maintenance

Defeasance and yield maintenance can be used in situations in which a multifamily investor wants to exit a loan early, but there are key differences: 

• Yield maintenance: A borrower paying a loan early pays a premium on top of the remaining principal. The yield maintenance premium is typically the greater of 1% of the principal being repaid or the premium calculated with the following formula: 
  
  Yield maintenance premium = present value of remaining mortgage payments * (interest rate – Treasury yield)
• Defeasance: The loan remains in place until it matures, so there’s no prepayment premium. Instead, the cost primarily depends on the value of the securities purchased as replacement collateral. 
  

Estimating the cost of defeasance is more complex than calculating a loan’s prepayment premium, and costs vary depending on the interest rate environment and Treasury yields: 

• Rising interest rates: Both options tend to cost less when interest rates rise. With defeasance, higher Treasury yields mean borrowers need to purchase fewer securities to generate cash flow to cover the remaining mortgage payments. Higher yields also result in lower yield maintenance premium payments. But if the borrower seeks a new loan, it will be at an elevated interest rate. 
• Falling interest rates: The farther Treasury yields drop below the borrower’s interest rate, the larger the prepayment premium. Defeasance also tends to cost more because at lower yields, the borrower would need more Treasury securities to serve as substitute collateral. However, a low interest rate environment could lead to a better rate on a new loan. 

Determining which option is more cost-effective depends on the individual borrower’s situation and original loan terms.