Yield Maintenance Simplified

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!

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

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.

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.

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.

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