If interest rates have moved lower and you decide it's time to refinance your home, it is simple to do so.
Prepayment risk is a part of almost all residential mortgages, and most have no pre-payment penalty whatsoever. Commercial mortgages are usually different, however. Many of them are only for a 10-year term with a 30-year amortization. In addition, most of them make no provision for pre-payment. Rather than trying to find a way to pre-pay, many commercial borrowers have taken up the practice of defeasance.
What is defeasance?
To defease is to replace the cash flows you are paying on your loan with other cash flows of equal value. In other words, your current loan on a commercial property is secured by the building. With defeasance you purchase securities to replace the cash flow that your lender receives from you. Commercial lenders just want to receive their cash flows as written out in your loan documents. Pre-payment would result in a substantial loss to the lender including all of the transaction costs.
Typically, defeasance involves purchasing some type of Treasury security to replace the cash flow. Thus, you would buy enough of the treasury securities for the lender to ensure that they are receiving the same amount of cash that they would have received from your payment.
No gain to defeasance per se
Unlike refinancing a home mortgage, there is no gain to defeasance. To understand this we can look at the simple example of bonds. Let's say you buy a bond for $1,000 face value and it has a 10% coupon. If interest rates go down, the price of that same bond goes up. If the prevailing interest rate drops to 5%, the cost to purchase those 10% bonds (to replace the cash flow on your 10% interest loan) would go up accordingly. So purchasing those bonds for the same cash flow doesn't represent any gain to you. If you are defeasing you can't make a real gain simply on replacing the cash flows to the lender. So why do people defease?
Take your equity out
The main reason that people defease over time is to take their equity out of a project. Over years of owning a property you gain increased equity as you pay down your loan. For many people, having a huge chunk of equity in an office building doesn't make a lot of sense. It is better to leverage the building appropriately and use your equity elsewhere. Let's look at a quick example.
Say that you purchase an office building for $10 million dollars. You get an 80% loan-to-value loan, so you put $2 million in equity into the building. Over the next five years you pay down the loan to the point that you have another $1 million in equity in the building, bringing your total up to $3 million. Even better, rents have gone up and on a cash-flow basis your building is actually worth $15 million now. So you have a loan that has a balance of $7 million on a $15 million building. As an entrepreneur, you now have $8 million sitting in that building and it's not working for you elsewhere.
When you defease you can then put a new loan on the building. At 80% loan-to-value you could get a $12 million mortgage meaning you would be able to take out about $5 million of your equity to use in other projects. This is the real value in defeasance.