Yield Maintenance

Yield maintenance is the original prepayment protection mechanism in commercial real estate lending and remains widely used alongside defeasance. Its purpose is the same — to make the lender whole for the yield income foregone when a fixed-rate loan is prepaid early — but the calculation methodology and practical implications differ from defeasance in important ways.

The yield maintenance premium is calculated as the present value of the difference between the loan's remaining scheduled interest payments at the contract rate and those same payments discounted at the current U.S. Treasury yield for the remaining loan term. In simpler terms, the borrower pays the lender the amount needed to make the lender indifferent between receiving the loan prepayment now versus continuing to collect scheduled interest through maturity. The lower the current Treasury yield relative to the loan's interest rate, the larger the yield maintenance premium.

Consider a 10-year, fixed-rate commercial mortgage at 5.5% with seven years remaining. If current 7-year Treasury yields have fallen to 3.5%, the lender was expecting to earn 5.5% on the remaining balance for seven years, but the market only offers 3.5%. The yield maintenance premium compensates the lender for that 2% annual shortfall over the remaining term on a present value basis. The result can be a penalty equal to several percentage points of the outstanding loan balance.

Yield maintenance and defeasance produce similar economic costs for the borrower under most interest rate environments, but they differ in their legal and structural treatment. Yield maintenance results in a cash payment to the lender and full satisfaction of the loan. Defeasance results in the substitution of the real property collateral with government securities, technically keeping the loan alive (now backed by the securities) while releasing the real estate from the lien. This structural distinction matters for CMBS trusts and other securitized vehicles where the REMIC tax rules govern how loan payoffs are treated.

Some commercial loans include a step-down prepayment schedule instead of yield maintenance or defeasance — for example, a 5% penalty in year one stepping down to 4%, 3%, 2%, 1%, and then open (no penalty) in year six through maturity. This structure is common in agency multifamily loans and some balance-sheet commercial loans. Step-down penalties are generally less expensive than yield maintenance for borrowers who prepay in the later years of the loan term, though they provide less absolute protection to the lender than a yield-maintenance provision.