Traditionally commercial real estate lenders evaluate the risk associated with a loan request using metrics like the loan to value ratio (LTV Ratio) and the debt service coverage ratio (DSCR). While these are important, there is another metric, Debt Yield, that is becoming widely adopted as an evaluation tool for lenders. Despite widespread use, it is common for borrowers to express confusion about the term and its application in lending scenarios. It is the intent of this article to explain it.
What Is Debt Yield?
Debt Yield is a metric used by CRE lenders to evaluate the level of risk associated with a loan transaction. It is a measure of how long it would take the lender to recoup their funds should the borrower default on their loan. Mathematically, the debt yield formula is:
To understand how the debt yield formula works, it can be helpful to break it down into its discrete components.
Net Operating Income (NOI) is the amount of cash flow that a property produces after operating expenses have been paid. It is estimated as part of the proforma creation process and is calculated for each year of the investment holding period. However, it is the NOI for year 1 of the proforma that is used in the Debt Yield calculation.
The loan amount is self-explanatory. It is the amount of money that the lender is planning to advance to the borrower. However, the loan amount is not always known. As such, the Debt Yield formula can be rearranged as a way to quickly size a loan based on a standard debt yield. When rearranged, the formula looks like this:
To understand how each configuration of the formula works, an example is helpful.
Debt Yield – An Example
Suppose that an investor is looking to obtain a $4,000,000 commercial mortgage for the purchase of a multifamily building in New York. As part of their underwriting process, they have created the following proforma:
In the proforma, year 1 Net Operating Income is $398,000. With a loan amount of $4,000,000, the calculated debt yield is 9.95%.
Used the other way, assume that an investor is trying to figure out the maximum loan amount and they know that the lender requires a 10% debt yield for approval. In this scenario, they could take year 1 NOI of $398,000 and divide it by 10% to get an estimated loan amount of $3,980,000.
What Does The Debt Yield Mean?
It can be seen from the example above that the result of the debt yield formula calculation is a percentage, but what does this actually mean? This percentage is an estimate of the annual return that the lender could expect to receive should they have to take the collateral property back as part of the foreclosure process. Like other investments, the percentage has an inverse relationship to risk.
A lower debt yield implies higher leverage and therefore higher risk for the lender. Conversely, a higher debt yield indicates lower leverage and therefore lower risk. Naturally, this statement begs the question, “what is a good debt yield?”
Like many things in commercial real estate, the answer is, it depends. The debt yield depends on a number of factors including the property type, leasing activity, and the strength of the tenants, market conditions, and location. However, 10% is a generally acceptable debt yield for many lenders.
Benefits and Risks of Using Debt Yield
For lenders, there are a number of benefits to using debt yield as a way to assess risk. They include:
- It is easy to calculate
- It is a quick way to compare the relative risk in two different loan transactions
- It cannot be manipulated by adjusting the terms on the loan. Since it does not include typical loan parameters like interest rate, annual debt service, market value, or amortization period, it will remain the same no matter what changes are made to these inputs.
While these benefits are important, the main drawback to debt yield is that it really doesn’t provide any information about the credit risk associated with the transaction. It doesn’t look at the sources of repayment, how they are derived, or the value of the collateral. For these reasons, debt yield should not be used in isolation. Instead, it should be used as part of a suite of risk metrics included in the underwriting process.
How Can A Commercial Real Estate Investor Apply the Debt Yield to Their Own Underwriting?
From an investment standpoint the most useful application of the debt yield is as a way to size the potential loan for a property. If the lender’s required debt yield is unknown, 10% can be used as a proxy.
Interested In Learning More?
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