Resources



Commercial real estate lenders make their living by earning fees and interest.  If a borrower suddenly prepays a loan, the lender stands to lose out on the remaining interest payments.  As such, commercial lenders take steps to protect their earnings with a prepayment penalty.  Moreover, there are three types of these penalties:

  • Yield maintenance
  • Defeasance
  • Step down

In this article, we’ll explore how yield maintenance works, how its calculated and how it compares to other prepayment penalties.  Also, we’ll step through an example of a yield maintenance calculation and answer some frequently asked questions.

Video:  Yield Maintenance vs. Defeasance

What is Yield Maintenance?

Yield maintenance is a prepayment penalty that guarantees a lender’s rate of return on a loan.  It compensates the lender for the amount of interest that it would lose due to the prepayment.  After all, if the borrower pays off a loan, then the lender can’t collect further interest payments.  Obviously, this is a problem if interest rates fall after the lender makes the loan.  That’s because the lender will receive a lower yield (i.e., interest rate) when it relends the prepayment amount.

Yield maintenance ensures that the lender receives a payment equal to the present value of its potential loss.  The lower that interest rates fall, the larger the lender’s loss, and therefore the higher the yield maintenance penalty.

However, no harm occurs if interest rates rise after the lender issues the loan.  That’s due to the fact that the lender can relend the prepaid amount at a higher interest rate.  Nonetheless, yield maintenance agreements often require a minimum prepayment penalty, usually 1%, even if rates rise.  The golden rule most assuredly applies here.  He with the gold, makes the rules!

Apply For Financing

YM Clauses in Loan Docs

Yield maintenance clauses are very common on commercial mortgages and other CRE loans of $1 million or more.  Lenders like them because the yield maintenance clause protects the lender from potential lost revenue.  The clause also makes it easier for lenders to sell off the loans for securitization.  That’s because the clause guarantees a certain percentage return to the purchasers of the repackaged debt.

Borrowers might also welcome yield maintenance agreements if analysts expect interest rates to rise.  This is especially true if the yield maintenance agreement doesn’t require a minimum prepayment fee.  However, as we mentioned earlier, most of these agreements require a minimum 1% penalty.  Also, a prepayment clause makes these loans assumable.  Importantly, a buyer can assume the mortgage at the original interest rate without triggering the prepayment penalty.  That makes it easier to sell the property in a rising-rate environment as the buyer receives a discounted interest rate.

How to Calculate Yield Maintenance

The yield maintenance calculation incorporates the time value of money.  It does this by calculating the present value of the potential loss.  To calculate present value, you must discount future cash flows using a factor representing current market yields.

Usually, the discount factor is the Treasury yield on debt of the same tenor (i.e., period till maturity).  The result is a sum of money you receive today equaling the value of the future cash flows.  That’s because investing the present value amount at the discount rate earns the equivalent interest income.  The yield maintenance amount is the present value amount multiplied by the lost interest.

Borrowers use a yield maintenance calculator for yield maintenance formulas

The Yield Maintenance Formula

The yield maintenance formula is:

Yield Maintenance Penalty = Present Value of Remaining Payments x (Interest Rate – Treasury Yield)

The components of the formula are:

  • Present Value of Remaining Payments:  This refers to the present value of the remaining balance on the loan.  If the loan is interest only, the present value equals (1 –(1+r)-n/12)/r, assuming monthly payments.  In the formula, n equals the number of months remaining and r is the appropriate Treasury yield.
  • Interest Rate:  The interest rate on the original loan.
  • Treasury Yield:  This is the Treasury interest rate on new debt maturing at the same time as the original loan.

Clearly, the formula calculates lost interest on the difference between the original loan yield and the current Treasury yield.  For example, suppose the borrower were to repay a loan three years ahead of time.  Accordingly, you use the yield on 3-year Treasury notes in the calculation.

Example

Let’s say that you’ve taken out a 7-year commercial mortgage with a 30-year amortization schedule.  Commercial mortgages which have 30-year amortizations such as this would typically be for multifamily property (5+ units).  After exactly two years, you decide to prepay the loan, 60 months in advance.  The payoff amount is $600,000.  The loan has a 5% interest rate, and the current yield on 5-year Treasury debt is 3%.

The first step is to calculate the present value of the loan balance:

PV = (1 –(1+r)-n/12)/r= [(1 – 1.03-60/12)/0.03] x $600,000 = $2,747,824

Next, we calculate the yield maintenance penalty:

Yield Maintenance Penalty = Present Value of Remaining Payments x (Interest Rate – Treasury Yield)

= $2,747,824 x (0.05 – 0.03) =$54,956.49

Thus, the borrower will have to cough up an additional $54,956.49 at the time of prepayment.

If the Treasury rate had risen above 5%, the penalty would be 1% of the remaining balance, or $60,000.

Internal Cost of Funds Index

So far, we have used the loans original interest rate to calculate the yield maintenance penalty.  Instead, some lenders use their internal cost of funds index, or internal COFI.  This is the rate at which the lender would lend money on a similar loan it makes today.  In effect, this changes the spread with the corresponding Treasury rate to reflect current lending costs.

Yield Maintenance Calculator

You can use an online yield maintenance calculator to figure the penalty amount. For example, check out the yield maintenance calculator at Capital One.

TEST TEST

Yield maintenance is the repayment of the loan such that the lender is made whole.  Defeasance makes the lender whole in a different way.  It requires the borrower to replace the collateral with a portfolio of securities yielding the same amount as the original loan.  The portfolio continues to pay the borrower’s interest through the loan’s original maturity date.

Frequently Asked Questions: Yield Maintenance

  • What’s the difference between yield maintenance and defeasance?

    Yield maintenance is the repayment of the loan such that the lender is made whole. Defeasance makes the lender whole in a different way. It requires the borrower to replace the collateral with a portfolio of securities yielding the same amount as the original loan. The portfolio continues to pay the borrower’s interest through the loan’s original maturity date.

  • What is a step-down prepayment penalty?

    This is a prepayment penalty that corresponds to a predetermined sliding scale. The scale operates against the remaining loan balance as of the payoff date. For example, the scale might specify a 5% penalty in year one, 4% in year 2, and so forth. The penalty would continue to step down to a minimum 1% penalty.

  • How do I avoid a prepayment penalty?

    There are a few ways to do this. You might be able to obtain a loan without a prepayment penalty. You see this mostly for loans under $1M. Alternatively, you could have a property buyer assume the mortgage. Or, you could simply not prepay the loan. Furthermore, some loans have specific clauses that allow a borrower to sell a property, after a specified time, without a prepayment penalty. However, the penalty may stay in place if the borrower simply wants to refinance the loan.

  • What is a typical prepayment penalty?

    The typical prepayment penalty is between 1% and 3%. Of course, this range can vary with the remaining loan period and the interest rate. With a yield maintenance penalty, the amount depends on current Treasury interest rates. The cost of defeasance is the foregone interest income. Step-down penalties can start high, such as 5%, before they descend.

Related Articles



Testimonials

Eric D.
Pleasure to work with and extremely knowledgeable

Ronny was a pleasure to work with and is extremely knowledgeable. His hard work was never ending until the job was done. They handled a complex lease and guided us through entire process, including the paperwork. Not to mention a below market lease rate and more than all the features we needed in a site. We later used Assets America for a unique equipment financing deal where once again Ronny and team exceeded our expectations and our timeline. Thank you to Assets America for your highly professional service!

exp MFGroup
Great experience with Assets America

Great experience with Assets America. Fast turn around. Had a lender in place in 30 minutes looking to do the deal. Totally amazing. Highly recommend them to anyone looking for financing. Ronny is fantastic. Give them a call if the deal makes sense they can get it funded. Referring all our clients.

William P.
Assets America guided us every step of the way

Assets America guided us every step of the way in finding and leasing our large industrial building with attached offices. They handled all of the complex lease negotiations and contractual paperwork. Ultimately, we received exactly the space we needed along with a lower than market per square foot pricing, lease length and end of term options we requested. In addition to the real estate lease, Assets America utilized their decades-long financial expertise to negotiate fantastic rates and terms on our large and very unique multimillion dollar equipment purchase/lease. We were thankful for how promptly and consistently they kept us informed and up to date on each step of our journey. They were always available to answer each and every one of our questions. Overall, they provided my team with a fantastic and highly professional service!

Bob B.
The company is very capable, I would recommend Assets America

Assets America was responsible for arranging financing for two of my multi million dollar commercial projects. At the time of financing, it was extremely difficult to obtain bank financing for commercial real estate. Not only was Assets America successful, they were able to obtain an interest rate lower than going rates. The company is very capable, I would recommend Assets America to any company requiring commercial financing.

Ricardo L.
Assets America was incredibly helpful and professional

Assets America was incredibly helpful and professional in assisting us in purchasing our property. It was great to have such knowledgeable and super-experienced, licensed pros in our corner, pros upon which we could fully rely. They helped and successfully guided us to beat out 9 other competing offers! They were excellent at communicating with us at all times and they were extremely responsive. Having them on our team meant that we could always receive truthful, timely and accurate answers to our questions. We would most definitely utilize their services again and again for all of our real estate needs.

HMG R&D
Assets America is a great company to work with

Assets America is a great company to work with. No hassles. Recommend them to everyone. Professional, fast response time and definitely gets the job done.

DAC Team
Great experience

Ronny at Assets America has been invaluable to us and definitely is tops in his field. Great experience. Would refer them to all our business associates.

MF Group
We were very pleased with Assets America’s expertise

We were very pleased with Assets America’s expertise and prompt response to our inquiry. They were very straight forward with us and helped a great deal. We referred them to all our business associates.

Manny C.
Worked with this company for decades

I’ve worked with this company for decades. They are reputable, knowledgeable, and ethical with proven results. I highly recommend them to anyone needing commercial financing.

David B.
Top-notch professional

Ronny was incredibly adept and responsive – top-notch professional who arranged impressive term sheets.

Monte M.
Assets America helped us survive a very difficult time

Assets America helped us survive a very difficult time and we most definitely give them 5 stars!

Brent G.
Gave me direction to go

Ronny was very friendly and though we were unable to make something happen at the moment he gave me some direction to go.

Allan E.
Highly recommend them for any type of commercial financing

My business partner and I were looking to purchase a retail shopping center in southern California.  We sought out the services of Ronny, CFO of Assets America.  Ronny found us several commercial properties which met our desired needs.  We chose the property we liked best, and Ronny went to work. He negotiated very aggressively on our behalf. We came to terms with the Seller, entered into a purchase agreement and opened escrow.  Additionally, we needed 80 percent financing on our multimillion-dollar purchase.  Assets America also handled the commercial loan for us.  They were our One-Stop-Shop. They obtained fantastic, low, fixed rate insurance money for us.  So, Assets America handled both the sale and the loan for us and successfully closed our escrow within the time frame stated in the purchase agreement.  Ronny did and performed exactly as he said he would. Ronny and his company are true professionals.  In this day and age, it’s especially rare and wonderful to work with a person who actually does what he says he will do.  We recommend them to anyone needing any type of commercial real estate transaction and we further highly recommend them for any type of commercial financing.  They were diligent and forthright on both accounts and brought our deal to a successful closing.