This is perhaps the most common question I get from new investors in commercial real estate. Yield Maintenance is not a term that investors in residential real estate will ever encounter, and even on smaller commercial real estate transaction it is a rarity. But once commercial real estate loans exceed the $1MM mark, it becomes the common method of prepayment.
In simple terms, a yield maintenance prepayment is used to guarantee the lender a set rate of return on the loan, even if the loan is paid off early. The yield maintenance prepay is the calculation made at the time the loan is paid off, or paid down, to determine how much, if any, additional funds the lender needs to make his investment whole.
If at the time the loan is paid off rates are higher, then there is little to no prepayment because the lender is not harmed. He can go straight back into the marketplace and he can relend that money out at a higher rate of return than he was originally collecting.
However, if at the time of the prepayment rates are lower, then the lender is injured because he cannot relend that money and get the same rate of return. The “Yield Maintenance” prepayment penalty is the calculation of that lost income, which is a factor of the original rate, current market rates, and the remaining term of the loan.
For instance, let’s assume an investor borrows $1,000,000 at 5% for 10 years, and his loan has a prepayment penalty. On year five he wins the lottery and decides to pay off the loan early. They look at the current market interest rates and determine that today’s interest rate, on a similar 5 year loan (5 years because that is the remaining term of the loan) is 4%. The difference (or spread) is 1%. There are five years left on the loan so the bank would collect a 5% prepayment penalty, 1% spread times 5 years. If in that same example current rates were at 3%, the prepayment penalty would be 10%, 2% * 5 years).
If current market rates were higher, say 6%, the prepayment penalty would be zero, as the lender can go re-lend his money at a higher rate and so is not harmed at all.
A yield maintenance prepayment penalty is extremely common in commercial real estate, particularly in larger loan amounts where these instruments/loans are combined together with other similar loans and sold off on secondary markets. Whoever owns the instrument is guaranteed a certain percentage of return which creates an instrument that is easy to package up and sell off; it is extremely liquid. There is no early payment risk to the lender.
Many people new to commercial real estate are not comfortable with yield maintenance prepayment penalties. There is variability to them that borrowers are sometimes not comfortable with. However, yield maintenance prepayment penalties can be great benefits to clients. In a low rate environment, it is highly unlikely that there will be a prepayment penalty, as rates would be expected to rise in the future. Additionally, these loans are fully assumable, so in the event of a sale the new buyer can take over the existing financing, forgoing the concern regarding the prepayment penalty.
Please understand that this is a VERY simplified explanation of yield maintenance, for illustrative purposes only. Actually yield maintenance prepayments vary from lending institution to lending institution. Here are a few things to watch for and ask about:
• Is there a “minimum prepayment penalty”? In many yield maintenance prepayment penalty there is a “minimum” prepayment penalty of 1%, regardless of the spreads.
• All yield maintenance prepayment penalties use a “time value of money” calculation when calculating the full prepayment rate. The final prepayment will be substantially less than the simple calculation of the spread times the remaining term.
• Most yield maintenance prepayment penalties use the current market rate of the correspondent US Treasury bond when calculating current market rates., with the maturity rate of the treasury bond matching the maturity rate of the loan that has been prepaid.
• In many cases the face value of the loan, or original interest rate, is used as the baseline to calculate the interest rate (rate of return) that needs to be replaced. However, many lenders use a different metric, they use an internal cost of funds index. This internal COFI is basically the rate at which they would lend out money into the market place on a similar product at that moment in time when the existing loan is prepaid.
I hope that this helps your basic understanding of the yield maintenance prepayment penalty.
Written by: Shawn Harris, Sr. Vice President, San Diego Commercial & Business Financing