Yield maintenance and defeasance are two common methods used to compensate lenders for the loss of interest income on commercial loans. Both terms refer to prepayment penalties designed to preserve the lender’s yield, but there are some differences in how they work. Whether you’re refinancing or prepaying a commercial loan, it’s a good idea to have a firm understanding of those differences so you can make the most informed decision for your situation. A financial advisor can also help you determine which option fits your finances.
What Is Yield Maintenance?
Yield maintenance is a type of prepayment penalty that ensures lenders receive the same yield they would have earned if the loan had been held to maturity.
When a borrower prepays a loan with a yield maintenance clause, they are required to pay a premium that compensates the lender for the loss of future interest income. This premium is calculated based on the difference between the loan’s interest rate and the current yield on a comparable Treasury bond for the remaining loan term.
Example of Yield Maintenance
For example, let’s say you have a $5 million loan at a fixed interest rate of 6%, set to mature in 10 years. If you decide to prepay the loan after five years and the yield on a comparable Treasury bond is 4%, you would owe a yield maintenance premium. This premium would be calculated to make up for the 2% yield difference for the remaining five years of the loan.
Lenders prefer yield maintenance because it provides predictable compensation. However, for borrowers, it can be costly, especially in a declining interest rate environment.
Yield Maintenance Formula and Calculation
Calculating a yield maintenance premium involves determining the present value of the remaining loan payments and compensating the lender for the difference between the loan’s interest rate and the yield on a comparable Treasury bond.
Below is the formula used to calculate yield maintenance:
Yield Maintenance (YM) = PV of Remaining Payments × (Interest Rate – Treasury Yield)
Where:
- YM = Yield maintenance premium
- PV = Present value of remaining loan payments
- Interest Rate (IR) = The loan’s fixed interest rate
- Treasury Yield (TY) = Yield of a comparable Treasury bond for the remaining loan term
The present value (PV) factor is calculated using this formula:
PV Factor = [1 – (1 + r)^(-n)] ÷ r
Where:
- r = Treasury yield
- n = Number of months remaining
Example of Calculation
Let’s assume a borrower has a loan balance of $80,000 with an interest rate of 6% and a remaining term of four years (48 months). The Treasury yield for a comparable term is currently 4%. Here’s how the yield maintenance premium would be calculated:
- Calculate Present Value of Remaining Payments
Use the present value factor formula:
PV = [(1 – (1 + r)^(-n)) ÷ r] × Loan Balance
Substitute the values:
PV = [(1 – (1 + 0.04)^(-48/12)) ÷ 0.04] × $80,000
PV = [1 – (1.04)^(-4)] ÷ 0.04 × $80,000
PV = [1 – 0.8548] ÷ 0.04 × $80,000
PV = 0.1452 ÷ 0.04 × $80,000
PV = 3.63 × $80,000 = $290,400 - Calculate Yield Maintenance Premium
Multiply the present value by the difference between the loan’s interest rate and the Treasury yield:
Yield Maintenance = $290,400 × (0.06 – 0.04)
Yield Maintenance = $290,400 × 0.02 = $5,808
In this case, the borrower would owe a prepayment penalty of $5,808.
What Is Defeasance?
Defeasance is another prepayment mechanism used in commercial real estate loans where the borrower replaces the original loan’s collateral with other assets, typically government securities, that generate enough income to cover the remaining payments. The original loan remains in place, but the new collateral ensures the lender continues receiving scheduled payments as if the loan had not been prepaid.
Example of Defeasance
For example, say you want to refinance a $10 million commercial loan and before the maturity date. To complete a defeasance, you would purchase a portfolio of U.S. Treasury securities that match the loan’s payment schedule.
These securities are transferred to a trust, which uses their income to make the required loan payments. The borrower is then released from the loan’s obligations, and the lender continues to receive payments as originally agreed.
Defeasance is often used for loans securitized in commercial mortgage-backed securities (CMBS) because it allows the loan to remain in the security pool without disruption. While defeasance can provide flexibility for borrowers looking to refinance, it can be a complex and costly process, involving additional legal and administrative fees.
Yield Maintenance vs. Defeasance
Both yield maintenance and defeasance serve the same purpose of compensating lenders for early loan repayment, but they differ in several ways:
- Mechanism: Yield maintenance requires borrowers to pay a calculated penalty directly to the lender, while defeasance involves substituting the loan’s collateral with other income-generating assets.
- Loan continuity: With yield maintenance, the loan is fully repaid and closed. Defeasance, however, keeps the loan active, as payments continue through the new collateral.
- Cost structure: Yield maintenance costs depend on the interest rate environment, with penalties typically higher when market rates are lower than the loan rate. Defeasance costs include purchasing replacement securities and additional administrative expenses, which can be substantial.
- Use cases: Yield maintenance is common for loans held directly by lenders, while defeasance is often required for CMBS loans to maintain the integrity of the securitization structure.
- Flexibility for borrowers: Yield maintenance generally offers a simpler process, while defeasance provides greater flexibility for refinancing without disrupting the loan’s terms.
Frequently Asked Questions
Who Benefits From Yield Maintenance or Defeasance?
Both mechanisms primarily benefit lenders by preserving their expected yield. Borrowers may benefit indirectly by gaining the ability to refinance or restructure their loans.
Is Defeasance More Expensive than Yield Maintenance?
Defeasance can be more expensive due to the cost of purchasing replacement securities and additional legal fees. However, it provides flexibility for refinancing while keeping the loan intact.
Can Both Methods Be Negotiated?
In some cases, prepayment terms, including yield maintenance and defeasance, can be negotiated during loan origination. However, these terms are often non-negotiable in CMBS loans.
Bottom Line
Yield maintenance and defeasance both protect lenders’ interests, but they offer different advantages and drawbacks for borrowers. Considering the differences between these options can help investors and borrowers make more informed decisions when it comes to the complex nature of commercial loan prepayment. By evaluating costs, flexibility and loan structure, you can choose the approach that aligns with your investment portfolio.
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