Don’t Look Stupid When Discussing Yield Maintenance

The key to landing your first job in real estate private equity is to crush the interview. As an outsider to the industry, though, you run the risk of looking like an outsider if you don’t know the terminology forward and backward. No one wants to see that look on the interviewer’s face when you just said something that proves that you don’t know what you’re talking about. At Leveraged Breakdowns, we are committed to helping you become fluent in the language of real estate private equity and common interview questions. We also give you hands-on training with our real estate investment analysis online courses.

Why isn’t it Just A Prepayment Penalty?

Lenders love to throw in penalties in the event a loan pays off early. The early payoff could be due to the borrower refinancing or it could be due to sale of the property. The lender doesn’t really care. When lenders deploy capital, they do not want to see it come back early. They are managing cash flows and earning the spread between the loan rate and the cost of capital. And therein lies the rub. When loaned funds come back early, the funds received have to be redeployed at the then-current market rates. If market rates have dropped versus the interest rate on the prepaid loan, then the spread to the original cost of capital could be negative for the lender. Both yield maintenance and defeasance are risk management tools for the lender to recoup potential prepayment losses, but they approach the problem very differently. You need to understand the difference.

Defeasance

Defeasance is the process of substituting income producing collateral for the loan in exchange for releasing the real property that originally secured the loan. The most common substitution is with US Treasuries. Defeasance is a common feature in Commercial Mortgage Backed Securities (CMBS). When a borrower wishes to sell a property that is part of a CMBS securitization, the servicer will not release the property without suitable replacement collateral and income, in order to maintain the investment yield promised to investors.

The amount of securities needed to replace the income over the remaining term of the loan in question is determined, and the purchase price of those securities is the defeasance amount that must be paid by the borrower. The replacement securities are purchased and become the sole revenue stream back into the security, which is then able to continue to make the scheduled payments to the bondholders.

Yield Maintenance

Yield maintenance is common with commercial banks and private lenders like real estate private equity or hedge funds. Because the lender isn’t required to make bond payments back to investors that cannot be prepaid, the lender can accept a full prepayment along with the premium required to meet the original return on investment. If rates have gone up, the lender will be able to redeploy capital at a higher rate, resulting in little or no yield maintenance fee. If rates have dropped, the fee could be significant.

It is important to realize that when yield maintenance is calculated, it compares the rate for similar loans with similar remaining terms to maturity at the time of prepayment. In other words, if the loan is paying off in year seven of a ten year loan (thus three years remaining), the yield maintenance calculation will compare today’s three-year interest rate to the original interest rate, even though the original loan was fixed for ten years. This is because the goal is to maintain the original yield to the lender. Depending on the shape of the yield curve, you could be in a rising rate environment and still have a yield maintenance fee because the higher rate for the remaining term doesn’t exceed the interest rate on the note.

That Wasn’t So Bad...

It isn’t likely that you’ll get a real estate private equity interview question asking you to calculate a yield maintenance fee. You may, however, get a question that requires you to know the difference between yield maintenance and defeasance. And now you do! By tapping into the resources, questions, and training available on our real estate investment analysis online course, you can develop an intuition for these types of calculations that will make you an expert.