Debt Yield Ratio Calculation
The debt yield can be calculated by hand by dividing the subject property's NOI by the loan amount:
Debt Yield = Net Operating Income / Loan Amount
For example, let's say that a property's NOI is $100,000, and the total loan is for $1,000,000. You get the debt yield by dividing $100,000 by $1,000,000, which gives you a debt yield of 10%.
Alternatively, it is possible to use the equation to back into the loan amount that can be achieved when a specific debt yield is required:
Loan Amount = Net Operating Income / Debt Yield
If the lender's required debt yield is 10% and the subject property has a NOI of $150,000, the total permitted loan amount would be $1,500,000.
Lenders use the debt yield ratio to evaluate the risk involved with lending money to a property owner. By definition, it is the return the lender would receive if the borrower defaulted on the loan and the lender had to foreclose on the subject property. Calculated in percentage points, it is the return the lender makes from the real estate after the foreclosure. Therefore, debt yield is inversely related to risk. As the debt yield ratio goes up, the perceived risk involved with a loan goes down. For instance, a property with a 12% debt yield would be a lower risk asset than a property with a 8% debt yield. Generally, most lenders that use debt yield want the rate to be at least 10%.
DYR is common in the real estate industry, but it can also be used in any asset or endeavor that generates income and requires debt. Since it has the ability to judge risk without having to take into account market conditions, amortization periods, and interest rate, it is a solid indicator of investment risk. If lenders need to calculate risk and leverage simultaneously over the life of a loan, they may do so my using the debt yield ratio. This is different from other common formulas like DSCR, Capitalization Rate, and Loan to Value, which have the potential to be manipulated by extending amortization periods or changing market values.
What is a Minimum Debt Yield?
Some lenders use a minimum debt yield when assessing a loan during the underwriting process. The minimum is the lowest debt yield that a lender will accept before extending credit. For instance, if the minimum required debt yield for a loan is 11%, the underwritten debt yield for the loan amount must be equal to or more than 11% in order to make the loan.
Which Lenders Use Debt Yield and Why?
Banks and other lenders are always trying to find ways to analyze investment properties before lending, using a wide variety of formulas to determine risk. Debt service coverage ratio (DSCR) and Loan-to-Value (LTV) are both always used, but may be subject to manipulation by altering some of the formula inputs. However, debt yield to measures risk regardless of market conditions and is not subject to the same types of exploitation. In particular, the retail, industrial, office, multifamily, and hospitality sectors are perfect for using debt yield ratio calculations to help analyze credit risk.
Although the use of debt yield ratio is not as common as some of the other metrics (especially amongst conventional lenders), it is becoming more widely adopted by securitized and private lenders for use in evaluating investment properties. Underwriters for Commercial mortgage-backed securities (CMBS loans) are among the early adopters of DYR. Private bridge lenders, hard money lenders, and mezzanine financiers are now also utilizing the debt yield ratio in their lending assessments. In fact, this method has become the primary ratio for these lenders—becoming more important than even DSCR.
Debt Yield vs. DSCR
DSCR is the net operating income divided by the annual debt service (i.e. mortgage payments). Contrary to first glance, the debt service in the DSCR formula is not necessarily a static input. This input can potentially be shaped by lowering the interest rate used in the loan calculations or extending the amortization period for the potential loan. For example, if a loan is unable to reach a 1.25x DSCR at a 20-year amortization, it is possible to use a 25-year amortization to decrease the loan payments, thereby increasing the DSCR. Increasing the amortization period has the effect of the monthly loan payments, but also decreases the principal paydown, which increases the overall risk profile of the loan. However, this additional risk is not readily apparent while using LTV or DSCR.
Debt Yield vs. LTV
The loan-to-value ratio is another popular tool commercial real estate lenders use when underwriting loans and assessing risk. This is the total amount of the loan divided by the current appraised value of the subject property. Although the total loan amount in the LTV formula does not vary, the approximate market value of the property can change depending where we are at in the real estate or economic cycle, which can significantly impact the LTV. In the case of rapid market declines, this makes certain properties like foreclosures and other distressed properties hard to value. Market values are subject to volatility which means that LTV will fall short when comparing to the DYR, which remains static regardless of changing interest rates, amortization periods, and market conditions.
Debt Yield vs. Cap Rate
Debt yield and cap rate formulas share many similarities. A capitalization rate compares the net operating income to the total cost of subject property and is arguably the most popular method that investors and lenders assess a real estate investment for profitability as well as return potential. The goal of a cap rate is to find the the intrinsic, unleveraged rate of return for a given property.
Since cap rates and debt yield ratios aim to answer similar questions by using the NOI in different ways, they share some of the same methodology. Appraisers and Lenders use a cap rate in order to value a property and calculate its returns without leverage. Lenders use the debt yield formula to see the highest possible loan amount a property can sustain as well as gain a better understanding of their ROI in case of a foreclosure. When the debt ratio is higher, it means that incoming rents are increased in relation to the total payoff of the loan, making it unlikely to lose money in the case of borrower default.
Note: The commercial mortgage calculators displayed in this website should be used as a guideline and do not represent a commitment to lend. Commercial Loan Direct and CLD Financial, LLC are not liable for any calculation errors.