Yield Maintenance
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Yield maintenance is a type of prepayment penalty that enables lenders to receive the same yield from a prepayment of a loan that they would have received through scheduled monthly payments up to the loan's maturity date.
In execution, yield maintenance stipulates that a borrower pays the difference between the interest rate on the loan and the standing market interest rate on the prepaid capital up to the loan’s maturity date. Simply put, the purpose of yield maintenance is to compensate investors or lenders for the loss of future interest that occurs when a borrower pays a loan off early.
In most debt transactions, a borrower pays interest on the principal amount, which compensates the lender for the use of its money over a period of time. Interest dictates a lender’s rate of return and is the basis for projected earnings. In many cases, the interest on a loan makes up a portion of each and every scheduled payment, with the total value realized only once the note is paid in full. Prepayment penalties such as yield maintenance were introduced as a way to ensure that — even if a borrower were to pay a note off at a significantly earlier date — a lender would still receive the same expected yield for the loan.
How to Calculate Yield Maintenance
Yield maintenance premium calculations follow this 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 vs. Defeasance
In commercial real estate, prepayment risk is generally mitigated through one of two mechanisms: yield maintenance or defeasance. Both are designed to keep a lender whole, albeit through different methods. While yield maintenance actually results in the prepayment of the loan, defeasance tackles prepayment risk through the substitution of collateral. Through a defeasance clause, instead of paying a prepayment fee, the property that serves as collateral for the loan is swapped for another cash-flowing asset — typically treasury bonds.
Both mechanisms come with a few advantages and drawbacks. Loans with a defeasance clause remove the prepayment fee, but — unlike loans with yield maintenance provisions — usually come with a lockout period during which the borrower simply isn’t allowed to prepay. Defeasance’s major advantage occurs when an interest rate is higher than the note rate. In this situation, borrowers have a chance to pay off loans at a discount. That said, the execution process of a defeasance clause is highly complex and more time consuming than its counterpart, often making yield maintenance slightly more appealing to borrowers for its simplicity.
Explore Alternative Prepayment Penalty Options:
- Learn about Defeasance
- Learn about Step-Down Prepayment Penalty
Related Questions
What is yield maintenance in commercial real estate financing?
Yield maintenance is a type of prepayment penalty — like defeasance and step-down prepayment — that enables lenders to receive a similar yield from the prepayment of a loan than they would have received through the completion of scheduled payments on the loan. Yield maintenance clauses specifically require that if a borrower is to prepay a loan, they are required to also pay the difference between the interest rate on the loan and the standing market interest rate on the prepaid capital up to the loan’s maturity date as a penalty. In other words, the purpose of yield maintenance is to compensate investors or lenders for the loss of their future interest income that occurs when a borrower pays a loan off early. 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 benefits of yield maintenance for apartment loans?
Yield maintenance is particularly desirable for borrowers when interest rates are expected to rise — more so when the clause doesn’t specifically stipulate a minimum prepayment fee. The reason for this benefit is that yield maintenance in such a scenario allows a borrower to repay a loan at a present value discount. In addition, the inclusion of a yield maintenance clause typically denotes that the loan is assumable, which can be a highly desirable feature to some borrowers.
For commercial financing of $1 million or more, a yield maintenance clause is pretty common. After all, yield maintenance is arguably one of the best options for lenders to protect themselves from lost revenue. Lenders also find that yield maintenance helps them to sell commercial loans for securitization — besides being beneficial to the lender, yield maintenance clauses typically also guarantee a set percentage of return to the purchasers of the repackaged debt.
The main advantage of yield maintenance for apartment loans is the lower capital requirements compared to defeasance. While defeasance requires the acquisition of securities that offer a comparable yield to a bank, yield maintenance can be handled with a simple (although not insignificant) payment as a one-time penalty. This leaves capital available for other uses, whether it’s renovating a property or acquiring another building.
Another advantage is its simplicity — again, compared to defeasance. While your accountant will need to understand the nuances of the yield maintenance process for purposes of the calculation, once the calculations and payment are accepted by the lender, that’s it.
What are the drawbacks of yield maintenance for commercial real estate financing?
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. Source
How does yield maintenance affect the interest rate of an apartment loan?
Yield maintenance affects the interest rate of an apartment loan by ensuring that the lender receives a yield from the prepayment of a loan similar to the yield if the loan was paid through maturity. Yield maintenance clauses typically require that a borrower pays the difference between the interest rate on the loan and the standing market interest rate on the prepaid capital (up to the loan’s maturity date) as a prepayment penalty.
This is particularly desirable for borrowers when interest rates are expected to rise — more so when the clause doesn’t specifically stipulate a minimum prepayment fee. The reason for this benefit is that yield maintenance in such a scenario allows a borrower to repay a loan at a present value discount. In addition, the inclusion of a yield maintenance clause typically denotes that the loan is assumable, which can be a highly desirable feature to some borrowers.
What are the best strategies for negotiating yield maintenance in a commercial real estate loan?
The best strategies for negotiating yield maintenance in a commercial real estate loan depend on the current market conditions. If interest rates are falling, it may be more cost-effective to continue making payments on the existing loan than to exercise the yield maintenance clause. On the other hand, if interest rates are rising, yield maintenance may be the best option for protecting the lender from lost revenue.
It is important to consider the cost of yield maintenance in comparison to other prepayment penalty options. For example, a loan with a yield maintenance clause may be more expensive than a loan with a defeasance clause. Additionally, lenders should consider the benefits of yield maintenance for securitization.
Ultimately, the best strategies for negotiating yield maintenance in a commercial real estate loan depend on the current market conditions and the specific needs of the lender.