Monthly Archives: February 2020

The debt service coverage ratio and the loan to value ratio are the traditional methods used in commercial real estate loan underwriting. However, the problem with using only these two ratios is that they are subject to manipulation. The debt yield, on the other hand, is a static measure that will not vary based on changing market valuations, interest rates and amortization periods. Some lenders, typically non-recourse lenders such as Agency and CMBS lenders, focus on debt yield as a way to size a loan. Essentially, lenders will have a lower debt yield for less risky properties as there is a lower likelihood of a property defaulting on their mortgage payments. The Debt Yield Ratio is a financial metric used in commercial real estate to measure the annual net operating income of a property in relation to its outstanding debt.

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.

• Investors will need to boost NOI to maintain a sufficient DSCR when debt service increases.
• The items excluded from the NOI calculation, such as capital reserves, capital expenditures, and tenant improvements, are unrelated to the property’s core operations.
• A lender wants as high a debt yield as possible as this will give them more comfort because there is more income to support their loan.
• In short, it’s impossible to say what a good debt yield ratio is without a proper assessment of other property metrics as contextualised with the area or region’s property index and valuations through time.
• Thus, there is a constant push and pull between these metrics to try to achieve an optimal outcome for both lenders and borrowers.
• To calculate DSCR, divide the net operating income (NOI) of a property by the total amount of debt payments.

The debt service coverage ratio and the loan to value ratio have traditionally been used (and will continue to be used) to underwrite commercial real estate loans. However, the debt yield can provide an additional measure of credit risk that isn’t dependent on the market value, amortization period, or interest rate. These three factors are critical inputs into the DSCR and LTV ratios, but are subject to manipulation and volatility.

Commercial real estate lenders calculate the debt yield on a transaction by dividing the property’s net operating income (NOI) by the total loan amount. The ratio this calculation provides tells the lender how long it will take to get back the sum advanced if the borrower stops paying. Hence, from the lender’s viewpoint, a higher debt yield is a positive sign. Debt yield is a financial ratio that assesses the income-generating capacity of a commercial property relative to its debt obligations. It is calculated by dividing the property’s net operating income (NOI) by the loan amount.

Debt yield compared to other commercial mortgage risk metrics

Consequently, it provides a measure of credit risk that’s less susceptible to manipulation and changing market conditions. 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. 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).

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It is a standalone metric that does not use interest rates, amortization schedule of loans, LTV, or other variables. Therefore, the 5.0% debt yield will most likely result in the lender declining the requested loan unless the terms of the financing are adjusted, i.e. via a reduction in the size of the loan. Suppose a real estate lender is performing due diligence on a potential borrower who has requested $8 million in financing to purchase a property. Whilst a commercial property valuation is likely relatively accurate, it still falls within a fluctuating, volatile range.

Debt Yield Calculation

Moreover, the Debt Yield Ratio measures the financial health and profitability of a property from an investment perspective. Overall, debt yield is a metric that should be monitored when underwriting a new investment property. To calculate an asset’s debt yield, the property’s net operating income (NOI) must be divided by the total loan amount used to acquire the property. To get a clearer understanding of the calculation, imagine a commercial property with a net operating income of $600,000 that was acquired with a $2,500,000 loan.

The debt yield for this asset would be debt yield ratio $600,000 divided by $2,500,000 which equals 0.240 or 24%. 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. 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.

Lender’s Perspective:

Loans with low debt yields are considered riskier, as the lender would receive a smaller return in the event of foreclosure. Higher debt yields are less risky because the lender would receive a larger return and could recoup their losses faster. The debt yield is becoming an increasingly important ratio in commercial real estate lending.

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. Until the Great Recession, two metrics – loan-to-value (LTV) ratio and debt service coverage ratio (DSCR) predominated the real estate loan landscape.

• The higher the interest rate or shorter the amortization, the higher the debt service, and keeping NOI the same, the lower the DSCR.
• 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.
• To compensate for these failings, lenders typically throw debt yield into the underwriting mix.
• We recommend them to anyone needing any type of commercial real estate transaction and we further highly recommend them for any type of commercial financing.
• And just like LTV and DSCR, the debt yield will change over time depending on how the property performs.

Free Financial Modeling Lessons

With DSCR, the debt service is determined by the loan amount, interest rate, and amortization schedule. The higher the interest rate or shorter the amortization, the higher the debt service, and keeping NOI the same, the lower the DSCR. Investors will need to boost NOI to maintain a sufficient DSCR when debt service increases. Lenders focus on the “going in” debt yield, meaning ‘what will the debt yield be in year 1 using the year 1 NOI and initial loan balance’. Over time, the actual debt yield can fluctuate as the property’s NOI can move up or down and the loan amount typically decreases as principal is paid down. In other words, it measures how much the lender can make from a property if it forecloses on the owner.

Commercial lenders and CMBS investors want to make sure that low interest rates, low caps rates, and high leverage never again push real estate valuations to sky-high levels. A lender wants as high a debt yield as possible as this will give them more comfort because there is more income to support their loan. The debt yield is a critical metric used by lenders to assess the risk of a loan. It indicates the return a lender would receive from the property’s NOI if they had to take ownership in the event of a default.