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 metrics are important, there is another metric called debt yield that is becoming widely adopted as an evaluation tool for lenders. Despite the widespread use of debt yield, it is common for borrowers to express confusion about the term and its application in lending scenarios.
In this article, we’ll explain what debt yield is, how to calculate it, and the pros and cons for commercial real estate investing.
What is Debt Yield?
Debt yield is a metric used by commercial real estate 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. 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.
How to Calculate Debt Yield
Mathematically, the debt yield formula is net operating income divided by the loan amount:
The result of the debt yield calculation is a percentage that 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.
Components of the Debt Yield Formula
To understand how the debt yield formula works, it can be helpful to break it down into its discrete components.
Net Operating Income
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 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 loan amount formula is net operating income divided by debt yield and looks like this:
To understand how each configuration of the formula works, an example is helpful.
Example Debt Yield Calculation
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 is a Good Debt Yield?
Naturally, like many things in commercial real estate, the answer is “it depends.” Generally, 10% is an acceptable debt yield for many lenders. However, 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.
Benefits of Using Debt Yield
For lenders, there are a number of benefits to using debt yield as a way to assess risk. They include:
- Debt yield is easy to calculate
- Debt yield is a quick way to compare the relative risk in two different loan transactions
- Debt yield 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.
Drawbacks of Using Debt Yield
The main drawback to debt yield is that it really doesn’t provide any information about the credit risk associated with the commercial real estate transaction. Debt yield 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 Debt Yield to Their Own Underwriting?
From an investment standpoint, the most useful application of 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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