Defeasance is now a common feature of real estate finance, allowing a borrower to effectively prepay a loan that is not by its terms prepayable. A defeasance is a substitution of a loan’s real estate collateral with collateral consisting of securities—thus freeing up the real estate in order that it may be sold or refinanced—and a corresponding substitution of a new borrower for the original borrower. Defeasance is often seen in commercial mortgage-backed securities (CMBS) loans, in large part because of restrictions on prepayment of such loans that arise under the statutory scheme governing the real estate mortgage investment conduits (REMICs) used to package these loans for sale to investors.
As a general matter, prepayment restrictions and penalties protect lenders from borrowers’ prepaying their loans whenever interest rates go down (which would likewise force lenders to reinvest the prepayment funds at the then lower interest rate). Prepayment penalties can take a variety of forms, including amounts based on a simple percentage of the principal being prepaid and yield maintenance premiums based on the differential between the interest that would have been received by the lender on the amount being prepaid and the interest that would be earned on specified investments if the amount being prepaid were used to purchase such investments.
