Yield Maintenance 101
Financing a multifamily investment shares some similarities with financing any other real estate. Loan decisions are based on the creditworthiness of the borrower and the appraised value of the property. When investing in commercial real estate, though, an extremely common feature of multifamily loans is “yield maintenance,” which refers to a type of prepayment premium that protects lenders from an early loan payoff. Other options common to multifamily loans include defeasance, which allows borrowers to exchange their original property for the loan for a different asset, usually a Treasury security, or a declining prepayment penalty.
Prepayment premiums are common to most commercial real estate loans, including those purchased by Fannie Mae and Freddie Mac. In 2019, Fannie Mae and Freddie Mac funded about $148 billion in multifamily loans out of the annual total of approximately $364 billion, according to the Mortgage Bankers Association.
Benefits of prepayment premiums
Lenders or loan servicers, which collect the interest on mortgages, typically want some type of protection from an early loan payoff from a sale or a refinance. For borrowers, a loan with a prepayment penalty offers the advantage of lower interest rates since lenders are more willing to offer favorable terms when their risk of a loss is lower. Closing costs are also typically lower on a mortgage with a prepayment premium. Borrowers who plan to keep their loan for a period beyond the prepayment premium phase benefit the most from these loans, but even those with a shorter timeframe may want to discuss the calculated risk of a prepayment premium with their lender.
How prepayment options work
Prepayment premiums are in place as a way to discourage repayment of a mortgage before a certain duration of the loan term. Borrowers and lenders typically agree on the prepayment option prior to locking in their loan rate. Some options require a lockout period when the loan cannot be prepaid.
- Yield maintenance. A common yield maintenance expiration is six months prior to loan maturity, according to Fannie Mae, but borrowers can choose yield maintenance periods that range from three years to the full loan term. The formula to determine yield maintenance is typically either a minimum of 1% of the principal being prepaid or it is based on the loan balance on the payoff date, the remaining yield maintenance period and the current yield on Treasury bonds. Yield maintenance = present value of remaining payments on the mortgage x (interest rate – Treasury yield).
- Defeasance. While the prepayment premium on a loan with a defeasance option can be more complex to estimate, an advantage of this choice is that mortgage rates are usually as low as those with a yield maintenance clause and sometimes lower. Rather than paying a prepayment fee, the real estate collateral for the loan is replaced with another cash-flowing asset, typically a Treasury security or a Fannie Mae security. Loans with a defeasance clause typically have a lockout period, such as three years on a Fannie Mae loan, that prevent any prepayment. One advantage of defeasance is that if interest rates are higher when the loan is prepaid, the borrowers may be able to pay off their loan at a discount.
- Graduated or declining prepayment. Mortgages with a graduated premium typically have a lockout period of a few years when the loan cannot be prepaid and then a premium that gradually declines from, for example, 5% to 1% over several years. Interest rates are typically higher on loans with this option, but some borrowers prefer the predictability of knowing what the premium will be at different times because it is not tied to fluctuating interest rates.
Disadvantages of prepayment options
For borrowers, the advantage of a lower-cost mortgage for their multifamily property needs to be weighed against the risk of a prepayment premium. If you anticipate paying off a loan earlier than the maturity date, you may want to avoid a loan with a prepayment premium and options that include a lockout when the loan cannot be prepaid under any circumstances.
The primary disadvantage of a prepayment premium is that it discourages refinancing to a lower mortgage rate. A yield maintenance premium will be higher when mortgage rates are lower, often to the point that refinancing could be cost-prohibitive. For any multifamily investor, a loan decision should be made in conjunction with a business plan that includes an evaluation of how long they intend to keep the property and an estimate of the potential direction of interest rates.