Until the Great Recession, two metrics – loan-to-value (LTV) ratio and debt service coverage ratio (DSCR) predominated the real estate loan landscape. We still use them, but we now also use the debt yield ratio (DYR). Why? As we shall see, LTV and DSCR are dynamic numbers subject to manipulation to arrive at the desired outcome. Debt yield is a static ratio that doesn’t vary with variables such as interest rate, amortization period or cap rate. Therefore debt yield provides an objective measure of loan risk. A borrower seeking a loan with an insufficient DYR will fail underwriting, even with acceptable LTV and DSCR numbers. In effect, debt yield safeguards against loans on riskier properties.
What is the Debt Yield Ratio?
The formula for debt yield ratio is:
Debt Yield (DY) = Net Operating Income (NOI) / Loan Amount (LA)
All things being equal, the higher the debt yield, the less risky the loan.
What Are the DYR Components?
Debt yield measures net operating income (NOI) divided by loan amount (LA):
- NOI: This is the amount left over when you subtract operating expenses from the subject property’s gross revenue (i.e., rents). NOI excludes interest and tax expenses, but can include non-cash expenses amortization and depreciation. However, most commercial lenders prefer to use earnings before interest, taxes, depreciation and amortization (EBITDA) as the debt yield ratio numerator, because it better reflects the actual cash flows needed to pay back the loan.
- Loan Amount: Typically, this refers to the first mortgage on a property, although it also applies to commercial construction, commercial bridge and commercial refinancing loans. We specify first mortgage, because borrowers might also line up mezzanine loans at closing, but these have no effect on debt yield.
Video: How Do You Calculate Debt Yield on Real Estate?
Debt Yield Calculation Example
Let’s take a simple example. You seek a $10 million loan on a multifamily property you wish to purchase. Appraisers value the property at $14 million and it generates $0.9 million in net operating income. The DY on the property is $0.9 million / $10 million, or 9%. If the lender’s minimum debt yield ratio (DYR) is 10%, the commercial lender will require a larger equity contribution from the borrower or the lender will not approve the loan request. If the borrower agrees to kick in $5 million instead of $4 million, the loan amount drops from $10 million to $9 million while the debt yield rises to 10% (that is, $0.9 million / $9 million). This results in a less risky loan for the commercial lender and creates a higher chance of approval.
Assume the lender provide loans with up to 75% loan-to-value ratio (of course on a construction loan this would be a 75% loan-to-cost). We can see here how debt yield puts a cap on the loan-to-value amount. The original deal had an LTV of $1 million / $1.4 million, or 71.4%. As this is below the 75% ceiling, the lender might have agreed to this loan had it not also taken the DYR of 9% into account. By requiring a reduced loan amount due to dividend yield requirements, the lender avoids taking on a loan that it would consider too risky. The revised deal’s LTV is ($0.9 million / $1.4 million), or 64.3%. In conjunction with the new dividend yield of 10%, the lender can approve the loan application.
Debt Yield Ratio vs Debt Service Coverage Ratio
We earlier identified debt service coverage ratio as the other primary metric underwriters use to assess loan applications. The definition is:
DSCR = Net operating income / Total debt service
The LTV considerations for using EBITDA instead of NOI also apply to DSCR.
Total debt service is the borrower’s annual obligation to pay its debts on time. It consists of principal payments, interest payments and lease payments. This is the borrower’s total obligation, not just the one arising from the financed property.
In our example, assume the borrower has no other debts. The loan has a 20-year term and the interest rate is 4%. The principal repayment is $9 million / 20 years, or $0.45 million per year. The first year interest charge is 4% x $9 million, or $0.36 million, for a total debt service of $0.81 million. Thus, the DSCR is $0.9 million / $0.81 million, or 1.11. If the lender had a minimum DSCR requirement of 1.10, (which is lower than the usual value of 1.25), the loan would pass the underwriting standard, though in this example, just barely. Once again, debt yield ratio blocks a loan that would otherwise pass. Visit Debt Service Coverage Ratio for a more detailed discussion of DSCR.
The Current State of the DYR
You’re most likely to encounter a 10% DYR requirement from lenders. However, the current strong demand for mortgage-backed securities (MBS) means you are likely to find a 9% or lower DYR requirement from conduit lenders, as loan packagers reduce their underwriting standards to fill their appetite for MBS.
Required debt yields are lower in the hottest markets. For example, Denver recently saw Class A apartments requiring a debt yield of 7.5%, and downtown office space had a required debt yield ratio of 8.5%. In general, debt yields are lower for higher-end, less-risky properties in primary markets.
What Decisions Does Debt Yield Support?
Our discussion so far has viewed DYR as a gating factor in the loan approval process, along with LTV and DSCR. But commercial lenders also use debt yield to compare two similar borrowing requests. For example, suppose a lender had a choice between two different loan deals, each at an APR of 4.5%. The first deal has a 12% DY, while the second has a 7% DY. This gives the first deal the advantage, as it has an extra 5 percentage points downside room for NOI to decrease.
The growing influence of the debt yield ratio is due to its simplicity and its resistance to manipulation. It’s impervious to rate swings, stretched amortization periods or compressed cap rates. Assets America® works with a large network of commercial funding sources having a range of debt yield requirements. Assets America® is expert at matching the ideal commercial funding source to fit unique and specific commercial financing needs. If surety of execution is what you require, contact Assets America® today for all your commercial financing needs.
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For more information on commercial mortgages, check out these overviews of Closing Costs, Refinancing, and Credit. You can also use our Mortgage Checklist and find out which loan type is best for you.
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