Tuesday, 08 August 2017 00:00

Definition of Yield Maintenance and How it Applies

Yield maintenance can be a new and unfamiliar term to newer real estate investors. What is it? How does it work?

Essentially, yield maintenance helps ensure the lender and their investors achieve a minimum yield on the loans they make. They need to ensure they stay profitable, and deliver on their guarantees to others.

Yield maintenance typically shows up as a prepayment premium or penalty in mortgage loan documents.This is a standard feature in many commercial real estate loans. How much it is can depend on a combination of interest rate, points, pre-payment penalties, and interest rate trends.

How Yield Maintenance Works

There are no absolute rules when it comes to applying this factor. Each lender can apply their own calculations, and desired minimum yield.

In residential home loan lending a borrower may be familiar with standard 1-5 year pre-payment penalties. Typically, the penalty is 1% of the loan per year. It declines, the longer the borrower has had the loan. So, a loan with a 3-year pre-payment penalty may have a 3% penalty for early payoff in the first year. 2% in the second year, and 1% in year three.

In commercial real estate yield maintenance penalties can be far more complex. Some agreements are simple. Others can be a formula which is a page or more long. You must make sure you understand how it works, and what the potential costs are if you pay off the loan early, or sell the property.

Front line lenders and borrowers effectively create a bond when they originate a new loan. That becomes a security sold on Wall Street. End investors and those organizing these opportunities must ensure buyers of these securities receive full compensation, whether that loan is held until maturity or paid off early. Since the goal of most commercial property and rental property investment is for long term hold and ongoing income, lenders try to give borrowers the best possible rates, assuming they will stick to their entire commitment of the full loan term. When this doesn’t happen a yield maintenance clause ensures the investors are made whole.

A common, and most basic calculation for this may be:

Yield maintenance = present value of remaining payments on the mortgage x (interest rate – treasury rate)

As an example:

Loan interest rate: 6%

Maturity date: 11/9/20

Pre-paid on: 11/9/18 (2 years early)

Current 2 year treasury rate: 3%

Calculation

6% interest rate (loan coupon) – 3% treasury rate = 3%. Multiplied by 2, as there are two years left on the original note, = 6% prepayment premium.

Why You Want This Loan Feature

Yield maintenance and pre-payment penalties aren’t always a bad thing. In fact, you may want one.

Few things are certain in life. So, it can be beneficial to have flexibility. If we are in a declining rate environment it may be good to have the opportunity to refinance a loan, and lower costs and debt service, without penalty. In a rising rate environment it may be better to lock in a low rate for the longest possible term, regardless of yield maintenance.

If you are certain you will keep this property long term, then it may be most profitable to negotiate lower points and rates, in exchange for a heftier or longer yield maintenance clause. If you are simply trying to reposition a property, and hope to refinance or sell in the next 36 months, it may be vital to take a no prepayment loan, even if the rates are higher for now. It’s a balancing act.

Also look for features such as assumption clauses, which may allow you to sell the property and have the next buyer take over the existing financing. That could avoid any penalties, and make the deal even sweeter for prospective buyers.

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