Commercial Loan Defeasance Explained

Commercial loan defeasance explained in one sentence: you do not “pay off” the note in the ordinary sense—you replace the pledged building with a basket of Treasury (or Treasury-like) securities that is engineered to make the remaining payments on time, so the lender’s cash flow stays intact. The building can then be sold or refinanced free and clear of that mortgage. The securities, not your check, become the collateral.

That is why defeasance can cost more—or occasionally less—than writing a check for principal plus a yield-maintenance formula. The price is a function of Treasury yields versus the note rate, remaining term, and fees, not a flat “5% prepay.”

The U.S. Treasury’s page on Treasury securities is the official description of the instruments a defeasance portfolio is built from. The loan documents—not a blog—control whether your note even allows defeasance.

Commercial Loan Defeasance Explained: Substitution, Not a Favor

Most fixed-rate CMBS and many life-company or agency multifamily notes lock the investor into a prepayment regime. Three families show up on term sheets:

• Lockout. No prepay at all for a stated period.
• Defeasance. After lockout, you may release the property by substituting securities.
• Yield maintenance or a declining percentage. A formula or schedule instead of (or after) defeasance.

Defeasance exists because the loan was sold into a pool that promised investors a specific stream of payments. If you simply send principal early, that stream breaks. If you deliver Treasuries that pay the same dates and amounts, the stream continues. The servicer and a successor borrower (often a special-purpose entity created for the securities) step into the payment mechanics.

You still write large checks: the cost of the securities, a defeasance consultant, rating-agency or trustee fees, legal, and a successor-borrower fee. Those are transaction costs, not a mystery “penalty line” with no math behind it.

For the broader menu, see commercial loan prepayment penalty types and yield maintenance.

When Defeasance Costs More Than a Cash Payoff

Defeasance is expensive when the securities required to replicate the remaining payments cost more than the remaining principal. That happens when market Treasury yields are below the coupon on your loan (or below the discount rate the documents imply). You are buying a high-coupon payment stream in a low-yield world. The premium is the economic prepay.

A simplified picture:

• Remaining principal: $4,000,000
• Remaining payments: 7 years of amortizing installments at a 5.50% coupon
• Treasuries that match those payments: $4,280,000
• Fees: $45,000
• All-in to release the property: $4,325,000

Versus a hypothetical cash payoff of $4,000,000 plus a 1% fee ($40,000): defeasance costs more. Versus a yield-maintenance clause that would have been $410,000, defeasance might still win. You only know by running your documents and a current Treasury curve.

Open-window or “defeasance at par” language in the last months of the term can collapse the premium. Many notes allow a small par-prepay window before maturity. If your sale can wait for that window, the securities premium may go to zero and you only pay residual fees.

When Defeasance Can Cost Less

If Treasury yields have risen well above your coupon, the basket needed to replicate payments can cost less than remaining principal. In that world, a yield-maintenance formula that discounts remaining payments at a Treasury rate plus a spread can also shrink. Defeasance is not automatically the expensive option in a higher-rate tape.

You still pay fees, and some documents require you to deliver securities with a minimum cost equal to principal (you do not pocket a surplus). Read the surplus clause. Some structures apply leftover value back to the loan; others do not let you “buy cheap Treasuries and keep the difference.”

Model three numbers before you list the building or issue a refinance application:

1. Remaining principal and the exact remaining payment schedule (including any IO tail or balloon).
2. A defeasance consultant’s good-faith securities cost on today’s curve, plus fee stack.
3. The yield-maintenance or percentage prepay if the note allows an alternative.

Then add transfer-tax, defeasance timing (often 30–60 days of process), and whether the buyer’s financing can wait. A 223(f) or bank refinance that cannot close on the defeasance calendar is a failed exit, not a clever structure.

Process and Parties (Why It Is Slow)

A typical defeasance is a mini-closing:

• Borrower notice to the servicer within the required window.
• Consultant runs the portfolio to the document’s eligible securities list (often U.S. Treasuries; some older docs allowed agencies).
• Counsel for borrower, servicer, and sometimes the trustee.
• A successor borrower takes the securities and the payment obligation.
• An assignment or release of the mortgage so the property can transfer or be re-encumbered.

This is why you do not “defease on Friday because the sale is Monday.” Build the timeline into the purchase agreement. Commercial loan closing costs and due diligence should include a line for this if the existing note is CMBS-style.

Defeasance Versus Just Keeping the Loan

Assumption can be cheaper than defeasance. Many CMBS and HUD notes are assumable with a fee and a replacement-guarantor review. If the rate is below market, a buyer may pay you more for the cap rate and the cheap debt. Defeasing to deliver a free-and-clear building can destroy that value.

If you need cash-out above what an assumption allows, you may still defease and place new debt. Price that as a pair: defeasance cost plus new loan proceeds and rate. Sometimes a second-lien or a partial release (if the pool allows) is the lesser evil. Partial releases are rare and document-specific.

This site’s commercial conversations are business-purpose investment financing. Defeasance is an exit cost on existing debt, not a reason to pick construction or a spec project.

Have a commercial or mixed-use investment property in mind? Start with a confidential inquiry or call (907) 841-1600.

Request Commercial Info →

Frequently Asked Questions

Is defeasance the same as a prepayment penalty?

It is a prepayment regime. The economic cost is the premium (if any) of the securities plus fees, not a made-up percentage. It can be larger or smaller than a yield-maintenance number on the same day. The note tells you which regime you have.

Can I defease a small-balance commercial loan?

Defeasance is most common on securitized fixed-rate debt. Many small-balance and private notes use a declining percentage, a lockout, or yield maintenance instead. If your documents never mention defeasance, you cannot invent it. You also cannot ignore it if they do.

How long does commercial loan defeasance take?

Plan in weeks, not days. Servicer notice periods, securities settlement, and successor-borrower setup commonly run 30 to 60 days, longer if a document is unusual. Put the process on the sale or refinance critical path early.

What happens if Treasury yields move after I get a quote?

The securities are priced near closing. A quote from last month is educational. Lock the sale timeline and get an updated portfolio before you waive financing contingencies that assume a stale number.

Should I defease so a buyer can place new financing?

Only after you compare assumption (keeping the cheap debt) against defeasance plus new debt. If your rate is below market, assumption often preserves more value than a free-and-clear delivery.