Defeasance is the substitution of one type of collateral for another. The defeasance removes the lender’s lien against the Borrower’s property and gives the property owner clear title. With most loans, a Borrower wishing to remove the lender’s lien would simply prepay the outstanding loan balance plus any penalty. However, most conduit loans (also called CMBS or securitized loans) do not allow outright prepayment. Most property owners with a conduit loan must therefore arrange a defeasance to refinance, extract equity or sell their property without loan assumption.
Successor Borrower assumes loan obligations
While the original loan is not cancelled in a defeasance, nearly all the obligations and rights of the Original Borrower are transferred to a Successor Borrower. The Successor Borrower is created in the defeasance process and assumes the obligations of the Original Borrower for the loan. The Successor Borrower owns the portfolio of government securities that acts as substitute collateral in place of the Original Borrower’s property. The Successor Borrower uses the proceeds from that portfolio to make the regular loan payments until the loan reaches maturity.
Defeasance is Similar to Prepayment
It is important to be clear that defeasance is not technically a prepayment of the loan. The original loan remains in place until its maturity, but the Successor Borrower assumes the obligations of the loan. The main difference is the loan collateral becoming a securities portfolio instead of the Original Borrower’s property. From the Borrower’s financial perspective, however, defeasance is the same as a prepayment because the Original Borrower makes one lump-sum payment in exchange for eliminating all obligations under the original loan. For more on prepayment penalties for commercial real estate loans, read about how defeasance differs from yield maintenance.