What Is a Debt Yield in Commercial Property Loans?
Debt yield is a measure of risk for commercial mortgage lenders. It takes the net operating income of a commercial property into account 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 otherwise be obscured by low interest rates or lengthy amortization terms. You can calculate debt yield by using the following formula:
Debt Yield = Net Operating Income ÷ Loan Amount
To calculate the debt yield, divide the net operating income of a building by the loan amount, and the result is your debt yield percentage. For example, a property with a NOI of $500,000 that requests a loan of $5 million would have a debt yield as calculated below.
$500,000 ÷ $5 million = 10%
In general, 10% is the lowest debt yield that most lenders will accept, though some may be willing to go as low as 8.0%, especially for Class A properties in major MSAs or gateway markets. To determine the maximum loan amount a lender accepting debt yields of 10% could offer, you can use the same formula in reverse. Divide the NOI by the debt yield percentage — $500,000 ÷ 10% — to get a maximum loan amount of $5 million.
Debt Yield Compared to Other Commercial Mortgage Risk Metrics
Unlike other measures of loan risk, like debt-service coverage ratios (DSCR), loan-to-value ratios (LTV), and cap rates, debt yield is a static, consistent measure. DSCR can be reduced by longer amortization periods and low interest rates, and LTV and cap rates 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 led up to the 2008 market crash, commercial properties in certain areas were gaining as much as 20% value per year. For example, let’s say an investor purchased a property for $1 million with a $700,000, 70% LTV loan. Suppose in three years, the property’s value had risen by 30%, to $1.3 million. That same loan, assuming no equity had been built up, would have a significantly lower loan-to-value ratio of 53.8%.
In theory, if a lender only looked at LTV, the owner could potentially get a cash-out refinance up to 70% (about $900,000), extracting about $200,000 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 the 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
DSCR can 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 $6,600. 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 Rates vs. Debt Yield
Cap rates are determined by dividing the NOI by the current market value of a property. Just like LTV, cap rates can shift rapidly as a property value increases or decreases. So, for instance, if a $1 million property generated $100,000 in NOI each year, it would have a cap rate of 10% ($100,000 ÷ $1 million = 10%). However, if the property value increased to $1.3 million (like in the LTV example), the cap rate would fall to 7.7%. 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’s type, location, condition, and many other factors.
Which Lenders Look at Debt Yields?
Debt yields are generally the most important metrics for CMBS lenders, who experienced the most drastic financial issues during the 2008 meltdown. Bank lenders and agency lenders like Fannie Mae® and Freddie Mac® do not yet place significant emphasis on this metric. However, this may change, so it is still a good idea to keep debt yield in mind when looking for commercial real estate financing.