Yield Maintenance vs Declining Prepay: The price of locking in.

In roughly 4 out of 5 multifamily agency loans originated over the last decade, borrowers chose a yield maintenance type of prepayment scheme over declining prepay.

Was it a wise choice to lock-in or was is it shortsighted?

Comparing the two prepayment types over a 10-year loan term

For our use, we’ll look at two identical loans, one with 9.5 years of yield maintenance (YM) and another with a standard declining prepay (DPP).

*There is a rate difference between the two types of prepay - the reason for which we will discuss in the next section.

Declining Prepay

A common declining prepay penalty schedule is 5%, 5%, 4%, 4%, 3%, 3%, 2%, 2%, 1%, 1%. Each percentage number represents a fixed fee amount a borrower must pay in order to prepay early. The order corresponds to the year in which the prepay occurs. For example, prepaying in the third year corresponds to a 4% penalty whereas paying off in the 7th year corresponds to a 2% penalty.

In the above figure, our prepay “steps down” every 2 years as expected. The slight downward angle in between years is explained by the amortizing principle balance.

Yield Maintenance

Yield maintenance is a different sort of prepayment penalty that essentially seeks to mitigate the bond investor’s loss upon loan prepayment. In lieu of the anticipated interest income the bond investor was to receive from the loan, the bond investor is paid the present value of the ongoing spread between your loan’s interest rate and the benchmark, risk-free rate (in this example, the corresponding treasury).

In this graph, we’ve modeled 9.5 years of yield maintenance, which is common for a 10 year loan. The fluctuations here are due to the ongoing movements of the underlying treasury rate (and the enormous treasury moves toward the beginning of this past decade).

While the specific yield maintenance calculation can be found in this article, it is suffice to keep in mind that the lower the treasury, the greater the spread between it and the loan rate and therefore the greater the yield maintenance amount.

Side by Side

Placing the two types side by side, it would appear obvious that the yield maintenance provision essentially locks you in for a majority of the duration of the loan, given its prohibitively large prepayment amount.

To tabulate the figures from the above graph:

The graph shows us that yield maintenance is significantly higher than declining prepay until slightly after 2019 (and often, YM clauses include a greater of YM or 1% - this is why).

Savings from choosing YM

The above analysis is missing a key component, however. The type of prepay you select has a direct effect on the interest rate you pay. Since the bond investor’s yield is better protected under yield maintenance than declining prepay, the rate demanded will be less.

Though the precise difference between the two depends on a number of factors, primary is the duration of the prepayment term.

To graph the complete scenario, we should include the cumulative debt service savings you receive by selecting yield maintenance. We’ve assumed a 0.45% difference in APR, which is approximately the spread today.

Another way of looking at this is to subtract the cumulative savings from the yield maintenance prepayment amount:

Looking at the difference from this angle in the last chart, the effective yield maintenance matches declining prepay just before 2018.

To put figures to this graph:

The Refinance Scenario

In our analysis thus far, it still appears that prepayment with YM before 2018 is largely prohibitive, even when accounting for cumulative savings.

However, there is yet another item that we must take into account - the amortization of the loan and the absorption of the prepayment by the new loan.

After 7 years of principle payments, our unpaid principle balance (UPB) has amortized.

Furthermore, the property’s income & expenses have likely grown, which result in a larger loan available.

*This assumes an equivalent cap rate and that income and expenses grew at a similar rate, compounded annually. Increased loan amount based simply on increased cashflow - other factors were not considered.

While the prepayment penalty may be steep, there is often sufficient room between a new loan amount and the current UPB.

*This amount includes the cumulative debt service savings for YM.

Conclusion

Much can happen in 10 years. Loan rates will fluctuate, cap rates will eventually move (though they’ve been largely stubborn this last decade), and the property’s market may boom or bust.

This analysis is largely oversimplified since it keeps those variables constant. Still, by doing so we are able to tease out the differences between these two penalties.

Yield maintenance, with its reduced rate, looks a lot nicer on a term sheet. There are significant cumulative savings that rack up as well, and an early prepay may not be as prohibitive as typically assumed.

Alternatively, declining prepay has an obvious advantage - it grants flexibility, which will work to your benefit if markets move favorably, or even if they remain the same. That flexibility certainly comes at a price, but the ability to realize capital appreciation several years earlier, or even the flexibility to sell the property may very well be worth that price.

Bottom line: There are typically several prepayment options available to you. Compare each one from the perspective of the exit, not the entry.

TapCap can help you review the long-term financial impact different prepayment options will have.