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Valuing the Defeasance Option in Securitized Commercial Mortgages


  • Martin Dierker
  • Daniel Quan
  • Walter Torous


To protect the interests of investors, commercial mortgage loans pooled for the issuance of commercial mortgage-backed securities (CMBS) have restrictive covenants that discourage the borrower from refinancing. Such restrictions limit the borrower's ability to access any accumulated equity. The predominant means of accessing this equity today is defeasance. By defeasing a loan, the borrower substitutes the commercial mortgage with U.S. Treasury or agency obligations whose payments match those of the defeased mortgage. Therefore, defeasance is an exchange option whereby the borrower gives up the portfolio of Treasury or agency securities and in return receives the market value of the commercial mortgage plus the liquidity benefits arising from accessing the accumulated equity in the underlying property. The value of the option to defease is shown to depend critically on the rate of return that can be earned on the released equity, prevailing interest rate conditions, as well as the option's contractual features. Copyright 2005 by the American Real Estate and Urban Economics Association

Suggested Citation

  • Martin Dierker & Daniel Quan & Walter Torous, 2005. "Valuing the Defeasance Option in Securitized Commercial Mortgages," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 33(4), pages 663-680, December.
  • Handle: RePEc:bla:reesec:v:33:y:2005:i:4:p:663-680

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    Cited by:

    1. Varli, Yusuf & Yildirim, Yildiray, 2015. "Default and prepayment modelling in participating mortgages," Journal of Banking & Finance, Elsevier, vol. 61(C), pages 81-88.
    2. Andreas D. Christopoulos & Robert A. Jarrow & Yildiray Yildirim, 2008. "Commercial Mortgage-Backed Securities (CMBS) and Market Efficiency with Respect to Costly Information," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 36(3), pages 441-498, September.
    3. Driessen, Joost & Van Hemert, Otto, 2012. "Pricing of commercial real estate securities during the 2007–2009 financial crisis," Journal of Financial Economics, Elsevier, vol. 105(1), pages 37-61.

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