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Yield Maintenance & How to Underwrite It
June 8, 2021
This article is a deeper dive into yield maintenance prepayment penalties and how they can affect your business plan as well as your underwriting. Yield maintenance is a fee paid to a lender by a borrower in order to pay off their loan prior to maturity. The fee is calculated based on the loans’ interest rate, the prevailing risk-free rate and the remaining term of the loan. Based on this calculation, the lender is in effect able to receive the equivalent of all of the interest that they are missing out on from the remaining term of the loan. The severity of the prepayment penalty depends on the change in risk-free rates (10-year US treasury yield) from the time the loan was originated to when it is paid off. If risk-free rates are higher, then the prepayment penalty is lower, since a lender can theoretically re-loan out the money at a higher interest rate. The opposite is true if risk-free rates move lower since origination.
Essentially, yield maintenance provides lenders 100% call protection which is why lenders prefer this prepayment penalty and will offer the best terms in this structure. This prepayment penalty only applies to fixed rate loans since lenders are constantly exposed to market interest rates in floating rate loans. For borrowers, yield maintenance can be extremely expensive and often prohibits borrowers from prepaying their loan until there is around four years of term remaining or less.
I have almost never seen yield maintenance factored into an underwriting for a deal, which is bizarre since it can have such a large cost and/or influence on the outcome of an investment. One rationale is to make the assumption that the deal will be sold on assumption (no pun intended), meaning the future buyer will assume the existing financing to avoid paying the prepayment penalty.
Selling a deal subject the existing financing is absolutely a viable exit. However, it is usually not without its complications. Selling on assumption usually results in selling at a discount because the underlying financing is likely to not be as attractive as new acquisition financing since the existing debt may no longer have any interest-only payment period remaining. Furthermore, the existing debt may be at a low leverage point compared to the proposed sale price and while a supplemental loan may be able to gross up leverage to 75%, it is still unlikely to be as attractive as new debt.
Because of the potential for a reduced valuation due to the loan assumption, if an investor is planning to sell the property subject to the in-place debt, they should account for this by adjusting their exit cap rate slightly higher. By doing so, this will factor in the lower price the encumbered property will likely sell for in comparison to its free-and-clear value. So while you may not have to incorporate any financing fees or loan prepayment penalties upon exit, there still must be some adjustment for the fact that the business plan is assuming a loan assumption sale.