CMBS Defeasance Explained: How Treasury Substitution Prepayment Actually Works

The Mechanics of Defeasance

When you take a CMBS loan, the loan becomes part of a pool that gets sold as bonds to bond investors. Those bond investors are expecting a specific stream of payments from the pool over the life of the loans. If any single borrower in the pool wants to prepay, the bond investors still need their expected payment stream — so something has to substitute for the prepaid loan.

That 'something' is a portfolio of U.S. Treasury securities (or sometimes agency debt) that generates exactly the same remaining monthly payments your CMBS loan would have produced. You (the borrower) buy these Treasuries on the open market at current Treasury prices. The Treasuries get delivered to the CMBS pool via a successor-borrower entity that holds them specifically to make the required payments. Your property is released from the lien; the Treasuries take its place as the pool's source of cash flow.

The process: you engage a defeasance consultant. The consultant calculates the exact Treasury portfolio needed by matching each remaining loan payment (principal, interest, balloon) to a maturing Treasury. The consultant sources the Treasuries in the bond market. A successor-borrower LLC is formed to hold them. Documentation is coordinated with the CMBS servicer. The Treasuries get pledged; the lien gets released. Total timeline: 30-45 days.

Fees: the defeasance consultant takes 0.25%-0.5% of loan balance. Legal costs $50K-$100K. Successor-borrower setup costs $5K-$10K. These are in addition to the actual Treasury purchase cost — which is the variable that determines whether defeasance is cheap or expensive.

The Math: When Defeasance Is Cheap vs Expensive

The cost of the Treasuries depends on the yield curve at the time of prepayment relative to your loan's coupon rate.

**Scenario A: Your loan coupon is 7.00%. Current Treasury yield is 5.00%.** You need Treasuries to generate $7.00% worth of cash flow per year. But Treasuries currently yield only 5.00%. To generate the same cash flow stream, you must BUY MORE THAN $1 of Treasuries for every $1 of remaining loan balance. The premium above par varies with time to maturity and magnitude of rate difference — typically 5-15% of loan balance when the yield gap is 150-250 bps.

**Scenario B: Your loan coupon is 7.00%. Current Treasury yield is 7.00%.** Treasuries cost approximately par to replicate the loan payment stream. Defeasance is cost-neutral (plus small consultant + legal fees).

**Scenario C: Your loan coupon is 7.00%. Current Treasury yield is 9.00%.** You need Treasuries to generate $7.00% worth of cash flow per year, but Treasuries currently yield 9.00%. You can buy LESS THAN $1 of Treasuries for every $1 of remaining loan balance. Defeasance is CHEAP — possibly even a slight gain for the borrower.

The mathematical counter-intuitive: LOWER market rates = MORE EXPENSIVE defeasance (because you need more Treasuries). HIGHER market rates = CHEAPER defeasance (you need fewer Treasuries).

This is exactly opposite of what most borrowers intuitively expect. When rates drop and the borrower thinks 'great, I can refinance into cheaper debt,' the defeasance cost on the existing CMBS simultaneously spikes, often negating the refinance savings.

Why This Matters for CMBS Borrowers

Defeasance is the single largest structural risk most first-time CMBS borrowers underestimate. A 10-year CMBS loan at 7.00% coupon that prepays in year 5 when Treasury rates have dropped to 5.00% could face 5-10% of loan balance in defeasance cost — on a $5M loan, that's $250K-$500K.

That cost is in addition to the refinance origination fees on the new loan, so the total 'cost of getting out of CMBS early' can be 2-4% of loan balance in fees PLUS 5-15% in defeasance. On a $5M loan, total exit cost $350K-$750K. Most sponsors don't plan for this magnitude.

The practical implications:

**Plan your hold horizon BEFORE taking CMBS.** If you might need to sell or refinance before maturity, run defeasance cost scenarios to understand exit cost under different rate paths.

**Consider CMBS structures with open-prepayment windows.** Many CMBS loans have an 'open' prepayment period in the final 90-180 days before maturity where defeasance isn't required. If your expected hold is 9.5 years, you can prepay in the open window without defeasance.

**Consider bank debt if flexibility matters.** Bank balance-sheet debt has simple step-down prepayment penalties (typically 5% year 1, 4% year 2, etc.) that are predictable and typically lower than defeasance. Rate premium over CMBS is often 0-50 bps — worth it for borrowers who need prepayment flexibility.

**Consider shorter-term CMBS.** 5-year and 7-year CMBS structures exist (though less common than 10-year). If your hold is 5 years, a 5-year CMBS avoids the defeasance-at-year-5 issue because the loan matures at your exit.

Scenario Modeling Before You Sign

Before taking any 10-year CMBS loan, run three defeasance scenarios at your expected prepayment year (year 5 of a 10-year loan is a common target):

**Scenario 1 (+200 bps rate environment):** Treasury yields are 200 bps higher than your loan coupon. Defeasance is cheap. Exit cost small. Total cost ~2-3% of loan balance (fees + modest premium or discount).

**Scenario 2 (Flat rate environment):** Treasury yields match your loan coupon. Defeasance is cost-neutral. Total cost ~1-2% of loan balance (just fees).

**Scenario 3 (-200 bps rate environment):** Treasury yields are 200 bps lower than your loan coupon. Defeasance is EXPENSIVE — 5-12% of loan balance. Total cost 8-15% of loan balance.

If your deal only works if Scenario 1 plays out, you're betting on a specific rate path. That's not capital planning, that's speculation. Better to structure the debt so it works in all three scenarios — which may mean bank debt with predictable penalties, shorter-term CMBS, or an open-prepayment structure.

Defeasance consultants (Chatham, Commercial Defeasance Group, Newmark) offer free preliminary scenario analysis. Use it before signing the CMBS term sheet.

Yield Maintenance vs Defeasance

Some CMBS loans use yield maintenance instead of defeasance as the prepayment mechanism. The economic outcome is similar but the mechanics differ:

**Yield maintenance:** Cash prepayment penalty calculated as the present value of the difference between your loan's remaining payments and what the lender could reinvest at current Treasury rates. Borrower pays cash; no Treasury portfolio substitution. Simpler mechanically, similar total cost to defeasance in most rate environments.

**Defeasance:** Borrower buys Treasuries, delivers them to the pool, gets property released. More complex mechanically, similar total cost.

Defeasance became standard for post-2003 CMBS originations. Yield maintenance is more common in pre-2003 CMBS and some specialty CMBS products (hotel CMBS, SASB structures). Check your specific loan docs to confirm which mechanism applies — both have the same economic counter-intuitive: low market rates = expensive prepayment.