Yield Maintenance

A method for calculating prepayment penalty, yield maintenance considers the difference between prevailing interest rates and the contractual interest rate of the loan such that the borrower does not benefit from changes in interest rates and the lender is not disadvantaged by changing interest rates.

Yield Maintenance is generally calculated by finding the present value of the remaining cash flows due to the lender, discounted back at an agreed upon discount rate using an agreed upon benchmark rate (e.g. government bond yield), less the outstanding loan balance at the time of prepayment.

Putting ‘Yield Maintenance’ in Context

In this hypothetical case, consider “Elmwood Plaza,” a mid-sized retail center in Boulder, Colorado, financed through a $15 million commercial mortgage at a fixed interest rate of 6%. The loan was originated three years ago with a term of 15 years.

Due to improved market conditions and a major tenant’s expansion enhancing the property’s value and cash flow, Crestwood Real Estate Group is considering refinancing the loan to take advantage of current lower interest rates of 5%. However, prepaying their existing mortgage requires will incur a yield maintenance cost (i.e. penalty). To calculate yield maintenance in this case:

• Step 1: Calculate the remaining cash flows on the original loan, including principal and interest payments due over the next 12 years.
• Step 2: Discount these cash flows back to their present value using the current market rate of 5%.
• Step 3: Compare the present value of these payments, approximately $15.24 million, with the outstanding loan balance of $12 million.
• Result: The yield maintenance penalty would be approximately $3.24 million. This ensures the lender is compensated for the interest income they would have received had the loan not been prepaid.

This penalty calculation ensures that Crestwood Real Estate Group evaluates whether the potential savings from refinancing outweigh the cost of the yield maintenance penalty.