Defeasance is a legal process that can release a borrower from a debt security before its scheduled maturity date. This can help real estate investors own their property outright or offset their debt service against income from interest-bearing securities. Here’s what defeasance is, how it works, and how it compares to other mechanisms like yield maintenance and early repayment.
What is Defeasance?
Defeasance is a process by which a borrower can achieve permanent release from certain obligations of a debt security without having to refinance the underlying debt. In other words, defeasance can eliminate specific future cash payments owed on a bond issue.
Most bond agreements include a defeasance clause. This clause gives the borrower the right to defease their bond under certain circumstances. To exercise this right, the borrower must meet all of the requirements outlined in the clause.
Where present, the defeasance clause specifies the types of collateral securities that borrowers can use for defeasance and the minimum market value that these securities must have. The clause also details the conditions under which the borrower may defease their bond.
Note, however, that not all bonds have a defeasance clause. If your bond does not have a defeasance clause, you cannot use this process to retire your debt early. So, review your bond agreement’s terms carefully to fully understand the requirements and conditions associated with this process.
How Defeasance Works
Defeasance involves eliminating or nullifying a debt. In real estate, there are several ways to do this. In some instances, defeasance of a loan can be achieved simply by refinancing the debt with another lender. In that case, the borrower will have eliminated the first mortgage and potentially even reduced their payments or outstanding liability.
In other cases, defeasance in real estate is accomplished simply by paying off a loan without refinancing. Borrowers may do this by selling another property, raising capital from investors, or merely making early payments against your mortgage balance.
A third and much less common option in the case of real estate lending is offsetting the debt a borrower owes a lender with other interest-bearing securities (such as bonds) that they buy. These other securities then pay interest on a regular basis, and the interest paid covers the cost of servicing the debt owed to a lender. The borrower can sometimes use these securities on their book to effectively nullify their debt.
Under certain circumstances, the borrower may even be able to pledge their securities to the lender—thereby releasing them from future payments required by the original terms of the loan agreement.
When to Use Defeasance
Defeasance can be an attractive option for borrowers who no longer wish to be bound by their original loan agreement terms. The mechanism allows them, instead, to own their property free and clear or offset the cost of their debt service on their books against future income on interest-bearing securities.
It’s important to note, however, that defeasance is not a way to avoid default. If borrowers default on their new securities, they are still held liable for the full amount of the original debt.
Defeasance can also be a good idea for borrowers who want to take advantage of lower interest rates. In the event an investor defeases a loan by refinancing, they may be able to do so at a lower interest rate, thereby lowering their monthly payments and potentially the total interest to be paid over the life of the loan.
If you’re considering defeasance, speak with a financial advisor to determine whether this is the right move for you. Defeasance may not be a good fit for everyone, but in some cases, it can be an effective way to achieve your financial goals.
How to Defease a Loan
Refinancing or paying off a loan is relatively straightforward. Still, if you decide to achieve defeasance by buying securities to offset the cost of your debt service, you will need to set up a defeasance escrow account. Borrowers use this account to hold the collateral securities required for the defeasance process.
Follow these steps to set up a defeasance escrow account:
1. Find a Qualified Trustee
A qualified trustee is an organization or individual authorized by the SEC to hold collateral securities in a defeasance escrow account. After identifying a trustee, transfer the required collateral securities into the account.
2. Execute a Trust Agreement
This agreement outlines the terms of the defeasance process and ensures that all parties understand their rights and responsibilities. Once the defeasance escrow account has been set up and the trust agreement has been executed, the collateral securities are held in the account until they are needed to pay off the old bond.
3. Defease the Bond
When the time comes to defease the bond, the trustee uses the collateral securities to make the required interest and principal payments on the old bond. After the payments are made, the old bond is retired, and the borrower is released from their obligations under the original loan agreement.
Say you have a bond with a face value of $100 that pays interest semi-annually. The bond’s current market value is $105, and it has five years remaining until maturity. The interest rate on the bond is 5%. You decide you would like to defease this bond and take advantage of lower interest rates by issuing a new bond with a face value of $100 and an interest rate of three percent. To do this, you must find securities with a market value of at least $105.
You find two securities with a total market value of $110: a Treasury bill with a face value of $100 and a maturity date of one year, and a corporate bond with a face value of $25 and a maturity date of five years. You use these securities as collateral for the old bond, and are released from any future payments on the original debt. You are then responsible for making all future interest and principal payments on the new securities.
In this example, you have effectively swapped your old bond for two new securities—the Treasury bill and corporate bond. You have also locked in a lower interest rate for the remaining term of the original debt.
Yield Maintenance vs. Defeasance
Yield maintenance and defeasance are two similar but distinct processes. Both yield maintenance and defeasance can be used to retire a bond early, but there are some important differences between the two options.
With yield maintenance, the borrower pays the lender a premium to retire their debt early. This premium is typically equal to the interest that would have been paid on the bond over the remaining term of the loan.
With defeasance, on the other hand, the borrower pays off their debt using collateral securities. These securities are typically government bonds or corporate bonds. The advantage of defeasance is that it allows the borrower to lock in a lower interest rate for the remaining term of their loan.
Not all lenders allow borrowers to defease their bonds. If your lender does not allow defeasance, choose another option for retiring your debt early. If you’re considering yield maintenance or defeasance, speak with a financial advisor to determine the right choice for you.
Defeasance vs. Early Repayment
Defeasance is the process of retiring an outstanding loan to free up the title to a piece of property. One way of accomplishing this is by paying off a loan ahead of schedule, either with extra monthly payments or in a lump sum.
For borrowers who want to defease a loan without raising the case to pay it off entirely, defeasance can also be achieved by refinancing a loan or by buying yield-bearing securities (bonds) that pay enough interest to cover the cost of paying their loan.
Frequently Asked Questions (FAQs)
What is defeasance in real estate?
Defeasance is a process that borrowers can use to retire a bond early. To defease a bond, the borrower must pay off their debt using collateral securities. These securities are typically government bonds or corporate bonds.
Is defeasance a prepayment penalty?
No, defeasance is not a prepayment penalty. A prepayment penalty is a fee borrowers pay to retire their debt early. However, if a loan includes a prepayment penalty, borrowers may not be able to defease their loan without incurring additional costs.
With defeasance, the borrower pays off their debt using collateral securities. These securities are typically government bonds or corporate bonds. The advantage of defeasance is that it allows the borrower to lock in a lower interest rate for the remaining term of their loan.
What is the purpose of defeasance?
The purpose of defeasance is to allow the borrower to lock in a lower interest rate for the remaining term of their loan. This can save the borrower a significant amount of money over the life of their loan.