What is yield maintenance?
Yield maintenance allows lenders to maintain the yield on a loan paid off early. It involves the borrower paying a yield maintenance fee to compensate the lender for the loss of interest income resulting from the prepayment of the borrowed funds.
Consider a situation where a commercial real estate lender provides a 10-year loan to a borrower. After making regular repayments for seven years, the borrower pays off the outstanding loan balance before the maturity date. If the loan agreement contains a yield maintenance clause, the borrower would need to make two different payments to the lender:
- The present value of the remaining loan payments.
- A yield maintenance fee.
The yield maintenance fee is like a prepayment penalty. A subsequent section of this post will discuss the method used to calculate yield maintenance.
Yield maintenance vs. defeasance
At this point, it could be worthwhile to take a minute to understand the similarities and differences between yield maintenance and defeasance. Both mechanisms seek to ensure that the lender receives the exact yield envisaged when the loan transaction was entered.
Another similarity between yield maintenance and defeasance is that the two involve allowing the borrower to unencumber the financed real estate asset.
However, there is a crucial dissimilarity between yield maintenance and defeasance.
The former entails the borrower paying the present value of the remaining loan installments and a yield maintenance prepayment penalty to the lender. Defeasance, on the other hand, works quite differently. It requires the borrower to replace the collateral with government bonds that would generate an income stream equal to the remaining loan payments. There are no prepayment penalties involved in defeasance.
Yield maintenance vs. defeasance
| Yield maintenance | Defeasance | |
| Similarity | Both seek to ensure that the lender receives the original yield envisaged at the beginning of the transaction. | |
| Similarity | Both allow the borrower to unencumber the asset. | |
| Dissimilarity | Entails paying the present value of the remaining loan balance and a yield maintenance prepayment penalty. | The borrower must replace the collateral with government securities that provide the lender with a return equal to the scheduled payments on the loan. |
How does yield maintenance work?
The purpose of the yield maintenance clause in a loan agreement is to maintain the lender’s yield if the borrower decides to pay off the loan before its maturity date. The payment the borrower needs to make is calculated in two steps. The first is to work out the present value of the remaining loan balance. The next step requires the calculation of the yield maintenance prepayment penalty:
Unpaid principal balance
The unpaid principal balance refers to the amount that remains to be paid on the original loan. It is calculated in a manner described a little later in this post.
Prepayment penalty
The next step is to calculate the yield maintenance prepayment penalty. This figure is determined by multiplying the unpaid principal balance by the difference between the loan’s interest rate and the current Treasury yield on a Treasury security with the same term as the loan’s remaining term. This calculation will tell you the yield maintenance penalty, commonly known as the yield maintenance premium or yield maintenance fee.
How to calculate yield maintenance: Formula
Here is the formula to calculate yield maintenance:
Yield maintenance calculation example
The following example will help clarify how the yield maintenance formula works.
Consider a ten-year commercial real estate loan for $1 million at an annual interest rate of 5%. After five years, loan installments totaling $636,393 remain to be paid. The yield on a 5-year Treasury Note is 3.6%.
Here is the formula that we need to use:
Yield maintenance = Present value of the remaining loan payments multiplied by (I – T)
Yield maintenance = $581,609* multiplied by (0.05 – 0.036)
Yield maintenance = $581,609 X .014 = $8,143
*The present value of the future installments can be calculated in Excel or by using the following formula:
Benefits of yield maintenance
Including a yield maintenance clause in the loan agreement can be an advantage for both the lender and the borrower:
- Present value discount repayment: If the borrower identifies a new lender willing to advance funds at a lower interest rate, it is possible to pay off the existing loan by discounting the future rentals and paying an additional yield maintenance premium.
- Assumable loan feature: Loans with yield maintenance are assumable, meaning the borrower can transfer the loan to another party before the loan’s maturity date. This can be a valuable feature for the borrower.
- Lower capital requirement: Yield maintenance is far superior to defeasance in terms of capital required. The former requires the borrower to pay the discounted value of future rentals in addition to a yield maintenance penalty. However, defeasance involves providing government securities that will generate a cash flow equivalent to the original loan installments.
- One-time penalty payment: All yield maintenance requires is a one-time penalty payment to complete the procedure to close the transaction, which is a significant advantage over defeasance.
- Simpler process: Finally, the yield maintenance process is far more straightforward than the one for defeasance, which is known to be both time-consuming and complex.
Drawbacks of yield maintenance
Yield maintenance is not without its disadvantages:
- Costly in falling interest rates: Consider a situation where the borrower wants to take advantage of falling interest rates by refinancing the existing loan. The first step would be to check if the prepayment will be made within the yield maintenance period*. If it is, the penalty amount may exceed the benefit derived from the lower interest on the new loan. It would make no sense to repay the existing loan and take a new one. Even if the penalty is less than the interest rate benefit, it may eat up much of the difference in interest rates.
*Yield maintenance period: the period during which the borrower needs to pay a yield maintenance penalty on prepayment. - Expensive penalty for refinancing: The dollar amount of the penalty may be high, eroding the borrower’s profitability.
- Higher cost than other penalties in declining rates: Of the two prepayment methods discussed-defeasance and yield maintenance-the latter can cost the borrower more. However, defeasance is far more complicated.
Alternatives to yield maintenance
Here are two alternatives to yield maintenance:
Declining balance prepayment penalty
Also known as a step-down prepayment penalty. The prepayment fee payable by the borrower to prepay the loan decreases with the number of years from the origination of the loan.
Flat fee prepayment penalty
As the name implies, the borrower pays a flat fee to prepay the loan regardless of the number of years remaining until the maturity of the loan. Prepayment penalties of this type can be expensive for the borrower.
Key factors to consider when using yield maintenance
From a borrower’s viewpoint, including a yield maintenance clause in the loan agreement can be a good idea. It provides the opportunity to repay the existing loan and take a new one if interest rates fall. Additionally, if the property is to be sold, transferring the loan to the new buyer is possible.
The bottom line
Yield maintenance permits lenders to recover the losses they would make if the borrower pays off a loan before maturity. In effect, it is a penalty payable by the borrower. The primary advantage of yield maintenance is its simplicity. However, it could involve a significant payout, and in certain instances, it could even prevent the borrower from switching to a lower-cost loan.
