- Commercial real estate lenders use a variety of metrics, like Debt Service Coverage Ratio (DSCR) and Loan to Value (LTV) to measure the risk in a potential loan transaction.
- While these metrics are important, there is a lesser known metric that has gained prominence in recent years and it is known as Debt Yield.
- Debt Yield is calculated as a property’s Net Operating Income divided by the requested loan amount and it provides an indication of how many years it would take for the lender to recoup their loan in the event of a default.
- Debt Yield is particularly useful as a measure of credit risk because it is static. It is measured independently of the interest rate, amortization period, term, and cap rate, all of which can be manipulated to fit a loan’s approval criteria. It is also helpful as a tool to measure the relative risk between two loan requests.
- Debt Yield also has its limitations because it is only one data point. It does not consider the collateral property’s location, visibility, ingress/egress, condition, or tenant base.
- Debt Yield should be considered as part of a complete review of a loan request, not in isolation.
One of the major benefits of a commercial real estate (CRE) investment is the wide availability of debt financing at generally favorable terms. But, this doesn’t necessarily mean that a loan is “easy” to get. Because of the high dollar amounts involved, commercial real estate lenders perform a significant amount of due diligence on all loan requests to ensure that they are comfortable with the risk profile of the transaction. Traditionally, a loan’s risk is represented by two key financial metrics, Debt Service Coverage Ratio (DSCR) and Loan to Value (LTV), which are important, but there is another metric, Debt Yield, that has achieved prominence in recent years, but is commonly misunderstood.
In order to fully understand what Debt Yield is and how it works, it is first important to understand the general process that a lender uses to approve a loan request.
Loan Approval Process
When a bank or real estate lender makes a loan, they do so knowing that there is some level of risk that they will not be repaid in full. Each lender has a different level of risk tolerance that is codified in their “credit policy,” which is a document that outlines the parameters and requirements under which they are willing to approve a loan.
When a lender receives a loan request, their analyst/underwriter reviews the details of it and calculates a series of key metrics, which they then compare to the acceptable metrics in their credit policy. For example, a credit policy may state that a multifamily loan has a maximum loan to value ratio of 80%, but if the underwriter calculates it as 85%, it results in an “exception” that may impact their ability to approve the loan. One their analysis is complete, the Underwriter documents their findings in a “credit approval memo” and submits it to their “credit officer” for approval. The credit officer’s primary job is to compare the specifics of the loan request to the guidance outlined in the credit policy. If they are in compliance, the loan is approved, if they aren’t, the loan is declined.
The important point is this, a loan’s approval/denial decision is governed by the contents of the lender’s credit policy, which can vary from one lender to another. Among other things, the credit policy outlines acceptable LTV, DSCR, and Debt Yield Requirements.
What is the Debt Yield?
Debt Yield is a risk metric used by lenders to estimate how many years it would take to recover the loan amount should the borrower default. The larger the number, the more years it will take to recoup the loan, which means more risk for the lender. Conversely, if the number is smaller, it will take a fewer number of years to recoup the loan, which represents less risk for the lender.
Debt Yield is calculated as a property’s Net Operating Income (NOI) divided by the requested loan amount. For example, if a property produces $150,000 in NOI and the borrower is requesting a loan amount of $2,000,000, the resulting Debt Yield ratio is 7.5% ($150,000 / $2,000,000). As a general approximation, this means that it would take the lender 13.33 years (1/7.5%) to recoup their loan from the property’s Net Operating Income should the borrower default.
If the loan amount is unknown, the Debt Yield formula can be rearranged to approximate it. The formula is Net Operating Income (NOI) / Debt Yield. As described above, the minimum debt yield requirement can vary by lender, but 10% can be used as a general target. So, for example, if it is known that a property produces $150,000 in NOI and the Debt Yield requirement is known to be 10%, the total loan amount can be approximated as $1,500,000 ($150,000 / 10%).
Why Debt Yield is Useful
Fundamentally, Debt Yield is a measure of risk for the lender and it is used as an important data point when underwriting a commercial property loan request. It is particularly useful when comparing one loan request to another because it cannot be manipulated to fit a lender’s approval criteria. For example, a loan’s annual debt service can be changed with adjustments to the interest rate or amortization period used to calculate it. As such, another metric like the Debt Service Coverage Ratio can be “massaged” into fitting the lender’s approval criteria. This is not possible with the Debt Yield.
To illustrate this point, assume a financial institution has received two similar commercial real estate loan requests, the parameters of which are summarized in the table below:
From the table it can be seen that each property produces the same amount of Net Operating Income, but they have different capitalization rates, amortization periods, and interest rates. As a result, Loan #1 has a Debt Yield of 8.21% while Loan #2 has a debt yield of 10.25%. Because Loan #1 has the lower Debt Yield, it represents less risk to the lender and would probably be more likely to be approved. Again, it is important to stress that each lender has their own threshold for an acceptable Debt Yield. One lender may be OK with 8.21% while another may not be.
Limitations of Debt Yield
Debt Yield is just one data point amongst many that a lender considers when evaluating a loan request. On its own, it provides useful information about the credit risk in the transaction, but it doesn’t say anything about the property’s location, visibility, ingress/egress, tenant base, condition, or layout, all of which are equally important indications of the collateral’s desirability.
So, for this reason, Debt Yield should be taken with a grain of salt and considered within the context of other important measures of lending risk like LTV and DSCR.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When working with lenders on our own loan requests, we always ask what the Debt Yield requirement is and calculate it on our own to gauge the maximum loan amount possible.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.
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