The Magnificent Journey of Loan Defeasance: A Closer Look at a Powerful Financing Solution

Learn about loan defeasance, the process by which a borrower replaces their existing loan with a pool of financial assets to release collateral. Follow our guide to understand the benefits, steps, and requirements involved in loan defeasance.

Loan Defeasance

Introduction

Loan defeasance refers to the process by which a borrower sets aside funds in an escrow account to absolutely guarantee the repayment of a loan at a future date. It is a common mechanism used in commercial real estate financing to reduce risk for lenders and provide an additional layer of security for both parties involved in the transaction.

The Defeasance Process

When a borrower seeks defeasance, they collaborate with a third-party payment firm, which oversees the process ensuring proper documentation and adherence to regulations. Here's a brief overview of the defeasance process:

1. Selection of an Independent Verification Agent (IVA): The borrower hires an IVA who reviews the terms and conditions of the loan and confirms the feasibility of initiating defeasance.
2. Selection of Replacement Treasury Securities: Treasury securities are purchased with the funds in the escrow account, typically matching the remaining principal and interest payment schedule of the loan.
3. Transfer of Ownership of Treasury Securities: The borrower transfers ownership of the newly purchased Treasury securities to the bondholders, effectively satisfying the loan's repayment obligation.

Benefits of Loan Defeasance

The use of loan defeasance offers several advantages to borrowers and lenders:

• Risk Mitigation: Defeasance effectively removes the risk of default for the borrower, as the funds held in escrow guarantee future loan repayment.
• Cost Savings: For borrowers, defeasance can lead to significant long-term cost savings, as the associated fees can be lower than traditional loan prepayment penalties.
• Lender Flexibility: Lenders are more inclined to provide better loan conditions when they can secure their investment through defeasance.
• Income and Tax Considerations: Defeasance allows borrowers to benefit from continued income generation from collateral properties and potentially avoid negative tax consequences that may arise from prepayment penalties.

Conclusion

Loan defeasance is a structured process aimed at reducing risk and ensuring full repayment of a loan. It provides peace of mind to both borrowers and lenders, effectively guaranteeing the fulfillment of financial obligations associated with a loan. If properly executed, loan defeasance can offer several benefits to borrowers and result in better loan terms and conditions.

Previous term: Bond Defeasance