What is Debt Yield In Commercial Property Loans?
Debt yield is a measure of risk for commercial mortgage lenders. It takes into account the net operating income of a commercial property to determine how quickly the lender could recoup their funds in the event of default. Some lenders prefer this method to other ways of measuring loan risk, which might be obscured by low interest rates or lengthy amortization terms. You can calculate debt yield by using the following formula:
To calculate the debt yield, divide the net operating income of a building by the loan amount, and multiply by 100 to arrive at a percentage. For example, a property with a net operating income of $500,000 that requests a loan of $5,000,000 would have a debt yield of $500,000 / $5,000,000 x 100 = 10%. In general, 10% is the lowest debt yield that most lenders will prefer, though some will go as low as 8.0-9.0%, especially for class A properties in major MSAs (i.e. New York City, Los Angeles, Washington D.C.). To determine the maximum loan amount a lender accepting debt yields of 10% would offer, we can simply do the reverse, taking the NOI ($500,000) and dividing it by 10% to get $5,000,000.
How Debt Yield Compares to Other Commercial Mortgage Risk Metrics
Unlike other measures of loan risk, like debt-service coverage ratio (DSCR), loan-to-value ratio (LTV), and cap rate, debt yield stays the same. DSCR can be reduced by longer amortization periods and low interest rates, and LTV and cap rate can be subject to changes in the market that vary the assessed value of properties. This is intentional, as vast increases in property value could easily make a loan appear far less risky for a lender than it actually is.
LTV vs. Debt Yield
During the real estate bubble that lead up to the 2008 market crash, a commercial properties in certain areas were gaining as much as 20% value per year. For example, if an investor purchased a property for $1 million with a $700,000, 70% LTV loan, and, three years later, the property value had risen 60%, to $1.6 million, that same loan (assuming, for this exercise, that no equity had been built up), would be at a stunningly low 44% LTV.
In theory, if a lender only looked at LTV, the owner could potentially get a cash-out refinance up to 70% (about $1.1 million), extracting about $400,000 in cash from the property. However, if the market crashed, bringing down the property to it’s pre-boom level, this would leave the borrower underwater (at around 110% LTV) and, most likely, unable to repay their mortgage. However, if the lender had only looked at debt yield, they would never have permitted a refinance, since, even during real estate booms, NOI is unlikely to increase more than 5% per year.
DSCR vs. Debt Yield
As we mentioned previously, unlike debt yield, DSCR can also be easily manipulated by changing the terms of a loan. For example, if a lender offered a borrower a $1 million loan at a 5% interest rate and a 20-year amortization, the monthly payment would be $6,599.56. If we assume the property generated $7,000/month in NOI, then the DSCR would be at 1.06x, which wouldn’t be acceptable to most lenders. However, if we increase the amortization to 30 years, the property would have a DSCR of 1.30x, which would be acceptable, considering most lenders look for a minimum DSCR of 1.25x. A similar situation would occur if the interest rate was reduced from 5% to 3.5%; with a 5% interest rate, the DSCR in the example above would still be 1.06x, while if it was reduced to 3.5%, the DSCR would increase up to 1.20x.
Cap Rate vs. Debt Yield
Cap rate is determined by taking the NOI and dividing it by the current market value of a property. Just like LTV, cap rates can easily be manipulated with increases in property values. So, for instance, if a $1 million property generated $100,000 in NOI each year, $100,000/$1 million = 10%. However, if the property value increased to $1.6 million (like in the LTV example), the cap rate would fall to 6.25%. While lenders occasionally look at cap rates, they are typically used by investors determining whether a property is a good investment. A “good” cap rate can significantly vary depending on a property type, market location, condition, and other factors.
Which Types of Lenders Look at Debt Yields?
Right now, debt yield is the most important for CMBS lenders, whom experienced the most drastic financial issues during the 2008 meltdown. Bank lenders and agency lenders (i.e. Fannie Mae and Freddie Mac), do not yet currently place significant emphasis on this metric. However, they may begin doing so in the near future, so it may still be a good idea to keep debt yield in mind when looking for commercial real estate financing.