One of the most common questions we’re asked by potential real estate investors and commercial property owners looking to refinance and take advantage of today’s low interest rates is regarding Yield Maintenance. A misunderstanding of what yield maintenance is and how it can effect the profitability of a financing or refinancing strategy can have significant negative repercussions for commercial property owners. That’s why we feel it’s important for us to shed some light on this seemingly “mysterious” topic.
What is Yield Maintenance?
Yield maintenance is a prepayment fee, or penalty, charged by the lender. The purpose of yield maintenance is to compensate the lender for the loss he incurs as a result of the borrower’s prepayment. For example, a bank that issued a 5 yr. loan at a specified interest rate did so with the intention of earning a projected return based upon that specified rate. When the borrower decides to repay the loan after only 2 yrs. in order to take advantage of lower mortgage rates, the bank’s earnings projections are invalidated since instead of getting their original (higher) yield, they can only reinvest their capital at the lower current rate.
The yield maintenance penalty effectively allows the bank to earn their original yield without suffering any loss due to lower interest rates. The bank can reinvest the money returned to them, plus the penalty amount, in safe treasury securities and receive the same cash flow as they would if they had received all scheduled mortgage payments until maturity.
How is it Calculated?
The yield maintenance formula is the present value of remaining loan payments multiplied by the difference between the loan interest rate and the rate on a Treasury note of the same duration.
Let’s look at an example:
David takes a 5yr. loan for $750,000 (disregard fees and closing costs) at a rate of 4.47%, 30 yr. amortization. The monthly payment on this loan is $3,787. The total amount to be repaid at maturity is $683,373.
David decides to refinance the loan at a lower rate after year 3. The total amount owed after year 3 is $711,819.
Assume that the 2 yr. treasury rate at year 3 is 2.37% , which is the rate that the bank will use if they have to reinvest the loan proceeds to obtain an amount equal to the total they would receive at maturity of the original loan.
In order to receive the original maturity proceeds ($683,373) the bank will need to invest $735,450 at the 2.37% treasury rate.
The prepayment penalty calculation: $735,450 – $711,819 = $23,630
(Note: Each lender might have slight variations to the above formula.)
Why should you choose a loan with yield maintenance if it means you’ll have to pay a possibly large penalty if you decide to prepay? Most long term loans (over 5 years) require it, so you don’t have much of a choice in the matter. Also, by guarantying the lender that they will receive their interest for the life of the loan, you will get a better rate. Typically, rates on loans with yield maintenance are 50-100 Bps lower than similar loans with step-down or more flexible prepayment penalties.
What happens if you decide to sell your property? Most lenders who make loans with yield maintenance allow for their loans to be assumed by a qualified buyer. If not, then the prepayment penalty should be factored into the sales price. Of course, if the borrower’s rate is lower than the current market rate, the borrower will receive either a cash payment or a discount in the amount of the calculated difference at the time the loan is paid off.
We hope this basic overview has been helpful in clarifying the often complex and misunderstood topic of yield maintenance. If you have questions or require assistance regarding a specific situation please contact one of our finance and investment specialists.