If you're in the business of commercial real estate investing, you'll be familiar with loan underwriting criteria such as the loan-to-value (LTV) ratio and the debt service coverage (DSCR) ratio. Banks commonly use these metrics in deciding if they should make the loan. Debt yield is the new kid on the underwriting block. Lenders like it because unlike LTV and DSCR, it does not rely on the market value, amortization period and interest rate which can either be manipulated or which change over time.
The debt yield calculates the risk associated with a commercial real estate mortgage by dividing the net operating income of the property by the loan amount.
Most banks apply two tests to assess the risk associated with a commercial real estate loan: the debt service coverage ratio and the loan-to-value ratio. The DSCR formula assesses whether the net operating income from the property – all the rent and revenues from the property minus its operating expenses – exceeds the mortgage payments with a healthy buffer, so you still have enough money to pay the loan even if expenses go up or the rent comes down. For example, a lender may require a net operating income (NOI) of $1.50 for every $1 borrowed.
The LTV ratio represents the amount of the mortgage lien divided by the value of the property. So, if you borrowed $500,000 to finance an $800,000 building, the LTV would be 62.5 percent. A low LTV of around 75 percent or less means the bank stands a good chance of getting its money back in a foreclosure sale even if the property has become less valuable over time.
The problem with LTV is that it changes as the property's market value changes, so it's hard to get a static measure of risk with this metric. Similarly, since the DSCR calculation relies on the loan's interest rate and amortization period, you can manipulate these factors to increase the DSCR. For example, raising the amortization period from 20 years to 25 years could achieve a lower annual loan payment and thus increase the DSCR to acceptable levels, even though the loan will cost more over time. To compensate for these failings, lenders typically throw debt yield into the underwriting mix. Debt yield offers another way to measure the risk of a commercial real estate loan using just the NOI and the total loan amount.
The math is simple to calculate debt yield: divide the property's net operating income by the proposed loan amount. For example, suppose you're buying a $1 million building, and the NOI is $50,000 per year. You have $300,000 in cash and would like to borrow $700,000 to purchase the building. The lender calculates a debt yield of $50,000/ $700,000 or 7.14 percent. Lenders generally set minimum debt yields before approving a mortgage. So, you'll find that lenders flip the calculation on its head to calculate the mortgage loan, where NOI divided by the debt yield gives the maximum loan amount. For example, if the lender requires a debt yield of 10 percent, then our $50,000 NOI property will only qualify for a $500,000 loan.
Eagle-eyed real estate investors will recognize that the debt yield definition looks a lot like a cap rate, which compares NOI to the price of the building – $50,000/$1 million in the above example or 5 percent. The similarity is intentional. That's because the lender is using the effective yield formula to understand what kind of return on investment it can expect on its money if it has to foreclose. A higher debt yield ratio means there's more rent coming in relative to the size of the loan repayment, so there's a fair chance the bank will not lose out if the borrower defaults on a mortgage payment.
Across the commercial real estate sector, the typical minimum acceptable debt yield is 10 percent. However, the actual number you're quoted will depend on the property type, financial strength of the tenant and interest rates. Risky property types such as hotels, which may have fluctuating vacancy rates and an unpredictable NOI, typically demand higher debt yields than more stable office investments. In lender speak, a higher debt yield indicates "lower leverage," which indicates a lower lending risk.