Debt Yield Definition and Explanation
Debt yield is a commercial real estate metric used by lenders to determine how long it would take them to get back their investment if the borrower defaulted on their loan and they had to foreclose on the property. Debt yield is calculated by dividing a property’s net operating income (NOI) by the total loan amount.
Debt Yield Example
As we mentioned before, the formula for debt yield is:
Net Operating Income (NOI) / Total Loan Amount
For example, if a property’s net operating income (NOI) was $500,000 and the total loan amount was $5 million, the debt yield would be:
$500,000 / $5,000,000 = 0.10 or 10% Debt Yield
This means that if you know the income of a property and a lender’s minimum debt yield requirement, you can calculate the maximum loan size the lender will permit. For example, if a property generated $300,000 in income and the minimum debt yield was 10%, you would divide $300,000 by 10% to achieve the maximum permitted loan size.
$300,000 / 0.1 = $3 million Max. Loan Amount
This also means you can also determine the amount of time in years it would take the lender to recoup their loan by dividing 1 by the debt yield and multiplying it by 100.
1/10 = 0.1 * 100 = 10 years
This assumes that the lender held onto the property until they fully recouped their investment, the property was repossessed immediately without cost, and the property did not appreciate during the lender’s holding period.
Debt Yield, The “4 Cs,” DSCR and LTV
Most lenders utilize something referred to as the “4 Cs” to calculate a borrower’s eligibility for a loan. These four elements are capacity, capital, collateral, and credit.
Capacity: Loan capacity can be determined by the income generated by the property, which can be found via the property’s DSCR, or debt service coverage ratio. DSCR is determined by taking a property’s net operating income (NOI) and dividing it by the property’s operating expenses, including monthly mortgage payments.
Capital: Capital can be determined by the net worth of the loan sponsor, which for Freddie Mac, Fannie Mae, and HUD multifamily loans must generally be at least 100% of the total loan amount, excluding the sponsor’s primary residence. CMBS loans often have lower net worth requirements, often as low as 25%-50% of the total loan amount.
Collateral: For non-recourse loans, collateral can be determined by the down payment on a commercial or multifamily property. Collateral is represented by a loan’s LTV or loan-to-value ratio.
Credit: Credit refers to the FICO credit score of the principal borrower or key principal borrower. Fannie Mae, Freddie Mac, and HUD typically require credit scores of 660-680+, while CMBS generally has lower requirements.
While the “4 Cs” are a good way to determine the risk of a loan, they don’t necessarily tell the whole story. Debt Yield provides another method, outside the traditional metrics, to determine the risk of a loan to a lender.
Unlike LTV, debt yield does not take into account the value of the property, which can swing wildly during real estate booms and busts, and instead only uses the outstanding loan amount to calculate risk. If a property falls in value during the term of a loan, the LTV will increase, adding risk, but the debt yield will stay static.
For example, if a $1 million property with a $100,000 NOI had a 70% LTV, $700,000 loan on it, but the value of the property fell to $900,000, the LTV would go up to 77.7%.
$700,000 / $900,00 = 0.77 / 77%
However, the debt yield would stay the same:
$100,000 NOI / $700,000 Loan = 14.2%
Like LTV, DSCR can be easily manipulated via certain conditions, primarily by changing the amortization or the interest rate of the loan.
For example, a loan with a 30-year amortization would give a property a much higher DSCR than if the loan had a 20-year amortization by decreasing monthly operating expenses.
Similarly, reducing a loan’s interest rate from 5.00% to 4.00% would also increase the DSCR by reducing monthly expenses, which could make a risky loan seem less risky than it actually is. However, even if the DSCR increases, the debt yield of the loan would stay the same. This static nature of debt yield is exactly why lenders like to use it as a measure of risk.
Debt Yield Requirements for CMBS Loans
Different lenders have different requirements for debt yield, with many requiring a minimum of 10%, with ranges of 8-12% being common. The higher the debt yield, the riskier a loan is for the lender and the more likely the loan is to go into default.
After the 2008 financial crisis, debt yield became more popular in the underwriting of commercial and multifamily loans. However, debt yield is most important to CMBS lenders, since CMBS loans are pooled together and sold on the secondary market as bonds called commercial mortgage-backed securities. A loan default would negatively impact the return of the bond, which is why CMBS lenders have to be especially careful during the underwriting process.
In many ways, debt yield is somewhat like a cap rate for a lender, as it provides a percentage-based metric about the viability of the investment. In the eyes of the lender, the loan itself is an asset that provides a specific rate of return and has a specific risk profile.
As we mentioned earlier, debt yield is also independent of factors like amortization and interest rates, so it makes it easier for lenders to compare the risk profiles of different loans.
In Conclusion: Debt Yield is One of Several Important Commercial Lending Metrics
All of this means that you, as the investor, should be aware of debt yield, along with LTV, DSCR, sponsor net worth, and credit score before submitting your loan application to loan brokers or lenders. Otherwise, you could be wasting your time or be unhappily surprised when a lender offers you a much smaller loan amount than you expected.