Learn about yield maintenance and how it is utilized as a prepayment penalty in commercial real estate finance.
What Is Yield Maintenance?
Yield maintenance — a type of prepayment penalty on some commercial real estate loans — enables a lender to receive the same yield from a prepayment of a loan that would have been received through scheduled monthly payments up to the loan's maturity date. Yield maintenance premiums were designed as a way to help make lenders indifferent to prepayment — while also making refinancing seem like a less attractive option for borrowers.
In most financing transactions, the borrower is required to pay interest on the principal loan amount. The interest that the borrower pays serves as compensation to the lender for the use of its money over a period of time. As far as lenders are concerned, interest represents their rate of return and is the basis for projected earnings. For a borrower, generally the interest on a loan makes up a portion of each and every scheduled payment, with the total value of said interest realized only once the note matures.
Prepayment penalties such as yield maintenance were introduced to counter any loss in profit a lender would face if a borrower were to repay a loan significantly earlier than agreed upon. The yield maintenance prepayment penalty specifically stipulates that the borrower must pay the difference between the interest rate on the loan and the market interest rate on the prepaid capital up to the maturity date of the loan.
How to Calculate Yield Maintenance
Yield maintenance premium calculations use the following formula:
**Yield Maintenance = Present Value of Remaining Payments on the Mortgage x (Interest Rate - Treasury Yield*)
***Treasury Yield = The current treasury interest rate on new debt with the same maturity date as the original loan.
Yield Maintenance Calculator
Yield Maintenance vs. Defeasance
In commercial real estate finance — particularly with CMBS loans — prepayment risk is generally mitigated through either yield maintenance or defeasance. Both of these prepayment penalties are designed to adequately compensate a lender in the event of prepayment on the loan, albeit through different methods. That said, while yield maintenance results in the actual prepayment of the loan, defeasance instead substitutes the collateral with cash-flowing financial instruments of relative value.
Both yield maintenance and defeasance each come with a few benefits and drawbacks. Yield maintenance, for example, generally comes with a prepayment penalty fee that borrowers must pay — and while loans with defeasance typically lack this fee, they do usually have a lockout period that prevents prepayment altogether for a set duration of time. The defeasance process is also notoriously complex, involving multiple parties and heavy analysis of financial instruments to replace the collateral on the loan. Still, while yield maintenance is the more simple option, defeasance does come with the possibility for borrowers to pay off their loans at a discounted rate.
What is yield maintenance in commercial real estate?
Yield maintenance is a type of prepayment penalty that is commonly used in commercial real estate financing of $1 million or more. It is designed to protect lenders from lost revenue when a loan is paid off early. Yield maintenance requires the borrower to pay a penalty that is equal to the difference between the interest rate of the original loan and the interest rate of a new loan that the lender could have obtained if the original loan had not been prepaid. This penalty is typically calculated as a percentage of the loan balance. Yield Maintenance Calculator and Defeasance or Yield Maintenance: Which Is Better?
How does yield maintenance work in commercial real estate?
Yield maintenance is a type of prepayment penalty that is typically used in commercial real estate financing of $1 million or more. It is designed to protect the lender from lost revenue if the loan is paid off early. The penalty is calculated by determining the difference between the interest rate of the existing loan and the interest rate of a new loan, and then multiplying that difference by the remaining principal balance of the existing loan. This amount is then paid to the lender as a penalty for early repayment.
The biggest downside of yield maintenance is that it can be more expensive than other prepayment penalties if the borrower plans to refinance at a lower interest rate. This is because the cost of yield maintenance may be greater than just continuing to make payments on the existing loan.
What are the benefits of yield maintenance in commercial real estate?
The main benefit of yield maintenance in commercial real estate is the lower capital requirements compared to defeasance. Yield maintenance can be handled with a simple (although not insignificant) payment as a one-time penalty, leaving capital available for other uses, such as renovating a property. Another advantage is its simplicity compared to defeasance. Once the calculations and payment are accepted by the lender, that’s it.
What are the drawbacks of yield maintenance in commercial real estate?
The biggest downside of yield maintenance occurs if this option is exercised in an environment where interest rates are falling. If a borrower plans to refinance at a lower interest rate, for example, the cost of yield maintenance may be greater than just continuing to make payments on the existing loan. As a result, the penalty could be far more expensive than if a loan had any one of a number of other prepayment penalties.
What are the alternatives to yield maintenance in commercial real estate?
The alternative to yield maintenance in commercial real estate is defeasance. Defeasance requires the acquisition of securities that offer a comparable yield to a bank. This can be a more complex process than yield maintenance, but it may be more cost-effective if interest rates are falling. Another alternative is to continue making payments on the existing loan, which may be more cost-effective than yield maintenance if interest rates are falling.
For more information, please see this article on defeasance vs yield maintenance.
How can yield maintenance be used to finance a commercial real estate purchase?
Yield maintenance can be used to finance a commercial real estate purchase by allowing the lender to protect themselves from lost revenue. The borrower pays a one-time penalty as a yield maintenance clause, which is typically lower than the capital requirements of defeasance. This leaves capital available for other uses, such as renovating a property or acquiring another building. Yield maintenance is also simpler than defeasance, as the calculations and payment are accepted by the lender once completed.