For owners of commercial property in Colorado, the decision to sell or refinance often hinges on the terms of their existing mortgage. While a straightforward prepayment might seem like the obvious solution, many commercial loans, particularly those bundled into Commercial Mortgage-Backed Securities (CMBS), explicitly prohibit or severely penalize early payoff. This creates a significant challenge for property owners eager to capitalize on market opportunities or restructure their portfolios, risking being locked into unfavorable loan terms.

The implications of being unable to prepay a commercial loan are substantial, potentially leading to missed investment opportunities or an inability to exit a property when market conditions are favorable. In such scenarios, a complex, yet often indispensable, financial maneuver called defeasance emerges as the primary, and sometimes only, viable path forward. GLO specializes in guiding commercial property owners through the intricacies of defeasance, explaining how this sophisticated process of collateral substitution works, highlighting the technical challenges and risks involved, and underscoring why expert legal and financial counsel is crucial to successfully navigate this complex transaction and achieve your commercial real estate goals.

The Technical and Risky Nature of Commercial Loan Defeasance

Defeasance is a highly technical financial and legal process, far more intricate than a simple loan payoff. For commercial property owners, misunderstanding its mechanics, failing to adhere to strict timelines, or attempting to navigate it without specialized expertise can lead to significant financial penalties, delayed transactions, or even the collapse of a sale or refinance.

The Mechanics of Collateral Substitution and Securitized Loans

At its core, defeasance is the process of replacing the original collateral for a commercial real estate loan—your property—with a new, equivalent set of collateral, typically high-grade, liquid assets like Treasury bonds or Agency securities. This is not a simple exchange; it involves meticulously selecting and structuring these substitute assets to generate the exact same cash flow (principal and interest payments) that the original loan would have provided to the lender or, more commonly, the bondholders in a securitized transaction. Many commercial loans are "securitized," meaning they are pooled with other loans and sold to investors as Commercial Mortgage-Backed Securities (CMBS). These CMBS bonds require a predictable stream of payments to their holders. Prepaying the underlying commercial loan would disrupt this income stream, hence the strict prepayment prohibitions.

The technical complexity arises in precisely calculating the amount and type of substitute securities needed, accounting for prevailing interest rates, yield curves, and the remaining term of the original loan. This calculation is typically performed by a specialized defeasance consultant or broker. The risk for the commercial property owner lies in the fluctuation of interest rates and the cost of purchasing these substitute securities. If interest rates have fallen significantly since the original loan was originated, the cost of purchasing the bonds that mimic the higher original loan yield can be substantial, often requiring the borrower to pay a significant premium. This "defeasance cost" can be hundreds of thousands or even millions of dollars, representing a major financial hurdle. Furthermore, coordinating the purchase and transfer of these securities, along with the legal release of the original Deed of Trust on the property, requires seamless execution and precise timing, often involving multiple parties including the loan servicer, the trustee, and the defeasance provider.

The Time-Sensitive Nature and Multi-Party Coordination

The defeasance process is inherently time-consuming and demands meticulous coordination among numerous parties, creating a significant risk profile for commercial property owners on a tight closing schedule for a sale or refinance. A typical defeasance can take 30 days or more to complete, and while it can sometimes be expedited for additional fees, initiating the process late in a transaction can cause critical delays or even derail a deal entirely. This timeline is necessary to allow for:

Loan Servicer and Trustee Engagement: Notifying the loan servicer and the bond trustee (in CMBS transactions) of the intent to defease, obtaining their requirements, and receiving their approval.
Defeasance Consultant Engagement and Bond Procurement: Working with a specialized consultant to calculate the precise bond portfolio needed and then actually acquiring those securities in the market. The bond market operates on its own schedule, and specific bond availability can impact the timeline.
Legal Documentation: Drafting and reviewing complex legal agreements, including a defeasance agreement, new pledge agreements for the substitute collateral, and the release of the original Deed of Trust on the property. These documents are often drafted by the lender's counsel and must be meticulously reviewed by the borrower's attorney.
Escrow and Closing Coordination: Coordinating the funding of the bond purchase, the transfer of the securities, and the simultaneous release of the property lien with the property's closing date.

The failure of any one party to perform their role efficiently, or a miscalculation in the bond portfolio, can lead to costly delays. For commercial property owners under contract to sell, a delayed closing can result in penalties from the buyer, renegotiated terms, or even the buyer walking away. For those refinancing, delays can lead to expiring loan commitments or increased interest rates. The ongoing negotiation and communication with the lender or note holder throughout this lengthy process also demands expert representation to ensure the borrower's interests are protected and the process is completed correctly and to their maximum benefit.

How GLO Can Help

Commercial loan defeasance in Colorado is a complex process requiring deep legal and financial expertise. At GLO, our real estate attorneys guide property owners through defeasance to facilitate smooth sales or refinances when prepayment is restricted.

We assess your loan terms, estimate costs and timelines, and coordinate with defeasance consultants to secure substitute collateral. GLO handles negotiations with lenders, loan servicers, and trustees, ensuring all legal requirements are met. We review critical documents—like the defeasance agreement and Deed of Trust release—to protect your interests and prevent delays. With GLO’s experienced counsel, you can complete your transaction efficiently and with confidence.

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GLO has prepared this blog to provide general information on legal issues that may be of interest. This blog does not provide legal advice for any specific situation and this does not create an attorney-client relationship between any reader and GLO or its attorneys. GLO engages clients only through specific signed fee agreements. GLO does not guarantee any results.

Defeasance — How You Can Sell Your Commercial Property When Prepaying Your Commercial Real Estate Loan Is Not Allowed