Musings on commercial
real estate finance
Yield Maintenance vs Declining Prepay: The price of locking in.
December 17th, 2019
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.
Figure 1: Graph of 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 Figure 1, 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 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).
Figure 2: Graph of Yield Maintenance
In Figure 2, 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.
Figure 3: Graph of Yield Maintenance Versus Declining Prepay
To zoom in on figures from the graph in Figure 3,
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).
Another way of looking at this is to subtract the cumulative savings from the yield maintenance prepayment amount:
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.
Figure 4: Graph of Cumulative Savings
Figure 5: Graph of Effective Yield Maintenance
Looking at the difference from this angle in Figure 5, 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.
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.
TapCap can help you review the long-term financial impact different prepayment options will have.
Bottom line: There are typically several prepayment options available to you. Compare each one from the perspective of the exit, not the entry.
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.
Growth New Loan*
YM Debt Savings Effective YM DPP
You've likely seen news articles recently about the U.S. Fed reducing interest rates and how this will lower mortgage rates across the board. You may be asking yourself how this might impact you.
Perhaps you're the type that always has CNBC playing in the background or maybe you simply look at mortgage rates when you need to (or when those ads pop up "mortgage bankers hate this guy for revealing this secret!"). In either case, not many investors, whether in the commercial real estate industry or outside, know all the ingredients that get stacked into their multifamily mortgage.
So let's break them out. For reference, we will look at a typical 10 year loan from either of the agencies, Fannie Mae or Freddie Mac. FHA, CMBS and other debt sources stack up a bit differently. However, considering that nearly half of multifamily transactions happen through one of the agencies, it's a good place to start.
Infographic: What goes into an agency rate?
August 20, 2019
At the base of our (fixed) rate is the U.S. treasury (floating rates use LIBOR as the benchmark instead). Since our example references a 10-year loan, the 10-year Treasury Note is used as the benchmark.
This rate fluctuates daily and impacts the entire industry.
Agency Guarantee Fee
This is the fee that the agencies receive in return for guaranteeing the loan. The role of a debt guarantor is outside the scope of this article, however investopedia has a good summary of the history and economic importance of this role. The agencies are able to compete with one another by adjusting their guaranty fee. They might also introduce special programs where they reduce their fee in order to incentivize real estate investors to either provide affordable units or become more energy efficient.
Investor Credit Spread
After your loan is originated, typically the agencies will purchase the loan from the lender and securitize it for sale in the secondary market. While agency guaranteed mortgage backed securities are considered very safe investments, they do have more risk than, say, a U.S. treasury note. How much more risk depends on investor outlook of the U.S. commercial real estate industry and is reflected in this spread.
Again, investopedia has a nice article summarizing credit spread, with a video tutorial to go along with it.
The treasury + the investor spread is also known as the pass-through rate, as that is the rate that is “passed through” to the bond investor. Using the infographic above, the pass-through rate here is 1.60% + 0.56% = 2.16%.
After your loan is funded, a loan servicer is appointed to collect your mortgage payments. The servicer serves several key functions, including ensuring that your property operations are compliant with the loan requirements and reporting asset performance to the bond investors.
For this service, the loan servicer collects an ongoing fee that is built into your interest rate. With agency loans, the lender typically remains as the servicer. The lender is able to adjust how much of a servicing fee they would like to include (subject to agency-set minimums).
Yield Spread Premium
All of the previous sections sum up to what is called par pricing. In the infographic above, par is 3.7%. At par, the lender does not receive any premium on the sale of the note.
Interest rates above par pricing will net the lender a cash premium. How much of a premium the lender receives is subject to the secondary market, but the mechanics are explained well in this article (specifically, the section on yield-to-maturity).
To use an example, let's assume that bond investors are willing to pay 1% more for every 0.15% increase in interest rate. In the above infographic, there is 0.30% built into the rate, which means a bond investor would pay 2% more for this loan. If the loan amount was $10M, bond investors would buy the note for $10,200,000 which means the loan originator would gain $200,000 in premium.
This is how agency lenders compete with one another. Typically a lender will quote a combination of upfront origination fee (sometimes referred to as the financing/placement fee) combined with some amount of yield spread premium built in. This total profitability can be shared with the mortgage broker as well (both the fee and the premium).
It should be noted that the agencies require that lenders charge some sort of minimum fee (via upfront fee & yield spread) for their service so that no lender can totally bottom-out the market.
While yield spread can be used as a way for brokers to make additional commission without borrowers knowing (the amount of yield spread built in is rarely communicated), it can also be used as a good tool for real estate investors looking to minimize upfront fees. Lenders are often able to move many of the upfront financing fees into the yield spread, which means your out-of-pocket can be significantly reduced (in return for accepting a higher rate).
So why is the rate on my loan quote different?
When you receive loan quotes from different lenders, there are several factors that could make one quoted rate higher than the next:
1. Assumptions on agency exceptions/reductions. Lenders may assume upfront that they will achieve certain interest rate reductions from the agencies based on their evaluation of your property. All lenders can apply for these exceptions, but some lenders will prefer to quote conservatively (not assume waivers) and over-deliver if they achieve an interest rate reduction.
2. Servicing fee. Lenders have the ability to reduce the servicing fee, subject to a minimum amount set by the agencies.
3. Yield spread. This is the most likely reason for differences in rate. In combination with financing fees, this is how much the lender will make on the loan. Since the revenue from upfront fees and yield spread both go to the lender, borrowers can request whether they want to pay more upfront and less in rate or vice versa.
It should be re-emphasized that the actual percentage breakdown is constantly shifting and that the above allocations are simply approximates.
At TapCap, our goal is to make the multifamily mortgage process simple, convenient & transparent for you. It is common for loan originators to try to keep certain items, such as yield spread and price waivers opaque. We put an absolute halt on this practice and instead remain completely transparent with you about your loan.
You can use the TapCap loan app to review accurate loan pricing, updated daily.
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