If you have applied for a commercial real estate loan within the past few years, you may have heard the term "debt yield" come up from your prospective lender. Most seasoned investors understand loan-to-value ("LTV") or the debt-service-coverage-ratio ("DSCR"), but scratch their heads when talking about this newer loan metric. Before we unravel the mystery, let's talk a bit about the two traditional metrics (LTV and DSCR) so that we understand why debt yield is used.
The loan-to-value ratio has long been the easiest way to understand how much of a loan can be acquired based upon the market value of the property and can be understood as the following calculation:
Total loan amount/Property Value = Loan to Value
Example: A $750,000 loan on a property worth $1,000,000 would equal a 75% LTV.
Notice how it states value and not purchase price. Different lender types utilize different LTV's based upon the property's market value and the amount of risk they are willing to take on. The problem with this easy calculation from the lender's perspective is how to determine the property's value based upon market capitalization rates. I will write a blog post later on how cap rates are manipulated and misunderstood in the marketplace, but suffice it to say that these metrics can be "massaged" and therefore are becoming less of a measuring stick for lenders.
The other benchmark for property performance is the debt service coverage ratio which uses the net operating income against the total annual debt charged on the amortized loan. The DSCR is calculated as follows:
Net Operating Income/Annual Debt Service = DSCR
Example: If a property's NOI totals $125,000 in the first year and the total annual debt service is $100,000 (mo. payment x 12), then the DSCR would equal 1.25.
Another way to think about DSCR and why it's called a "coverage ratio" is because the lender wants to see a healthy cushion between the amount of income the property covers over the amount of debt payments you pay to them. If you lose some tenants, are you still able to pay your mortgage? Traditionally, coverage ratios range between 1.20 - 1.30+ depending upon the lender type and risk profile. One problem with DSCR from a lender's perspective is that it can be manipulated by extending the amortization of the loan, which essentially reduces the total annual debt service and can help bridge the gap. But does that really reduce the risk for the lender? Probably not...which brings us to the debt yield calculation.
Debt yield (DY) was created to reduce the amount of unknowns when underwriting a loan and is a very simple calculation that is expressed as the following:
Net Operating Income/Total Loan Amount = Debt Yield
Example: If a property's NOI totals $125,000 in the first year and total loan amount is $1,250,000, then the debt yield is 10.0%.
Essentially this becomes an ROI calculation from the lender's side if they were to take back the property. An investor calculates their "return on investment" from taking the cashflow compared to the equity. In this case, the lender takes the cashflow from the debt. This also takes out a lot of unknowns, including cap rate, interest rates, amortization and valuations, which can muddy the underwriting waters. In general debt yields will vary depending upon the asset type, location, and risk profile. The less risky the property, the lower the debt yield threshold for the lender. You can now see why this is becoming a more widely used measurement of a property's viability during underwriting.
As investors we are constantly analyzing risk and investment metrics to determine if the reward is worth it. Lenders do the same thing, so it's important to see it from their perspective as well.
About the author:
Michael Hironimus, CCIM is the Certified Investment Advisor and Principal Broker for Duckridge Realty specializing in commercial real estate investment portfolios for high net worth clients and institutions, focusing on market, financial and risk analysis. He is also a faculty instructor for the CCIM Institute, teaching professionals globally in the CI-102 Market Analysis Core Course.
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