Is Yield Maintenance Right for You?
A yield maintenance prepayment penalty guarantees that the lender will attain the same yield on the loan, even if it gets paid off before the scheduled maturity date.
What Is Yield Maintenance in Multifamily Real Estate?
If you’re new to the world of commercial real estate, the phrase yield maintenance prepayment penalty has likely never been part of your vocabulary before. If you are trying to get a loan for a multifamily property, however, you must be aware of your prepayment options so you can make correct financial decisions in the long run.
A yield maintenance prepayment penalty is extremely common in larger loan amounts and essentially guarantees that the lender will attain the same yield on the loan, even if the loan is paid off before the scheduled maturity date. Fannie Mae and Freddie Mac are two of the biggest lenders that offer yield maintenance and other graduated payment options. Qualifying isn't always easy, however, as it requires a very experienced borrower, with a strong financial statement and rigorous underwriting of the property. Borrowers that don't qualify for Fannie Mae or Freddie Mac financing can find CMBS or life company loans as great alternatives.
If the loan is paid off early, the yield maintenance prepayment penalty is then calculated to determine the amount of funds the lender is entitled to in order to satisfy the investment. According to Fannie Mae, if the principal balance of the loan is paid off between the effective date and the yield maintenance period end date, the amount of the prepayment will be calculated as either: one percent of the amount of principal being prepaid; OR can be found by multiplying the present value of remaining loan payments by the difference between the loan interest rate and the Treasury rate that is of the same duration.
When Is Yield Maintenance Best?
In an environment where interest rates are stagnant or falling, a yield maintenance prepayment penalty can be a more expensive alternative for a borrower as opposed to a step-down, or declining prepayment penalty that is typically offered by banks (this is the most flexible type of option as your penalty can gradually decline over time but is geared more towards those who are seeking shorter-term loans). For example, the standard yield maintenance prepayment penalty can be as steep as 3% of the original loan amount in certain situations, whereas a step-down prepayment penalty over the course of a five-year loan can decline to 1% of the original loan amount.
The lender is also on the short end of the stick when interest rates are declining because they are not able to re-lend that money at the same rate of return after the loan is satisfied. In an environment where interest rates are rising, however, yield maintenance can actually be beneficial for both parties since the lender can now go back out into the marketplace and re-lend the money to a new investor at a higher rate– it’s a win-win for everyone.
Calculate Your Yield Maintenance Prepayment Penalty
Plug your figures into the calculator below. This will provide the cost of paying down a loan with a yield maintenance provision before it matures.
What is yield maintenance and how does it work?
Yield maintenance is a clause in a commercial loan agreement that requires the borrower to pay a premium if they pay off the loan before its maturity date. The premium is calculated using the present value of the remaining payments on the mortgage, multiplied by the difference between the interest rate and the Treasury yield. The Treasury yield is the current interest rate on new debt with the same maturity date as the original loan.
For more information, see Yield Maintenance: How to Calculate Yield Maintenance and Yield Maintenance Calculator: CRE Lenders and Yield Maintenance.
What are the benefits of yield maintenance?
The main benefit of yield maintenance is that it allows a borrower to repay a loan at a present value discount, which is particularly desirable when interest rates are expected to rise. Additionally, the inclusion of a yield maintenance clause typically denotes that the loan is assumable, which can be a highly desirable feature to some borrowers.
Yield maintenance also has the advantage of requiring 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, such as renovating a property or acquiring another building.
Finally, yield maintenance is simpler than 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?
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?
The alternatives to yield maintenance include defeasance, a step-down prepayment penalty, and a flat prepayment penalty. Defeasance is a process in which a borrower replaces an existing loan with a new loan and uses a portfolio of U.S. Treasury securities to pay off the existing loan. A step-down prepayment penalty is a penalty that decreases over time, while a flat prepayment penalty is a penalty that remains the same regardless of when the loan is prepaid.
For more information, please see Yield Maintenance: Calculator, Alternatives, Important Considerations and Defeasance or Yield Maintenance: Which Is Better?.
What factors should I consider when deciding whether to use yield maintenance?
When deciding whether to use yield maintenance, you should consider the expected interest rate environment, the assumability of the loan, and the benefits to both the borrower and the lender. Yield maintenance is particularly desirable for borrowers when interest rates are expected to rise, as it allows them to repay a loan at a present value discount. Yield maintenance is also typically a common feature for commercial financing of $1 million or more, and is one of the best prepayment penalty options for lenders to protect themselves against lost revenue. Additionally, yield maintenance clauses typically guarantee a set percentage of return to the purchasers of the repackaged debt. For more information, please visit www.commercialrealestate.loans/yield-maintenance-calculator.
What are the tax implications of yield maintenance?
The tax implications of yield maintenance depend on the type of loan and the borrower's tax situation. Generally, the borrower will be able to deduct the yield maintenance penalty as a business expense. However, the IRS may consider the penalty to be a capital expenditure, which would not be deductible. Additionally, the borrower may be subject to capital gains taxes if the yield maintenance penalty is considered a prepayment of principal. It is important to consult with a tax professional to determine the exact tax implications of yield maintenance.