Debt Yield Calculator

What Is a Debt Yield?

A key metric taken into consideration in commercial property finance, along with loan-to-value and debt service coverage ratios, is the debt yield of a property. The debt yield metric is important to some lenders, as it is one key factor for determining the risk of an investment. Understanding the debt yield helps lenders determine how long it would take for them to recoup their losses should they possess a property following a loan default. The metric is valued for being unaffected by factors present in other calculations which may prevent an accurate determination of risk. 

Other risk mitigation metrics such as LTV and DSCR are subject to inaccuracies caused by external forces such as market valuation, amortization periods, and interest rates, which are all driven by market conditions. Consider what happens when values in a market are heavily inflated and lenders begin competing on loan terms like amortization periods and interest rates. This doesn’t stop loans from successfully passing through the underwriting phase, but it can create the potential for much higher-risk loans should the market reverse course. With the debt yield metric, lenders have a standardized measure of risk that doesn’t rely on any of these variables.

Calculating Debt Yield

To calculate a property’s debt yield, you must divide the property’s net operating income (NOI) by the total loan amount. The formula, simply stated, is:

Net Operating Income ÷ Total Loan Amount = Debt Yield Ratio

For example, if a commercial property’s net operating income is $600,000 and the entire loan amount was $2.5 million, the debt yield would be calculated by dividing $600,000 by $2.5 million, giving you a resulting yield of 24%.

It isn’t uncommon to encounter loan programs or lenders that require a minimum debt yield ratio to mitigate risk. A useful side effect of this is that an investor can calculate a potential maximum loan amount for any such financial vehicle, provided the NOI of the property is known.

For example, all a borrower would need to do for a loan with a minimum debt yield requirement of 15% is take the NOI and divide it by the required debt yield ratio. Using the NOI from the earlier example above, a borrower would be able to take a loan out of up to $4 million, provided that amount was consistent with other factors, like LTV and DSCR.

$600,000 ÷ 15% = $4 million maximum loan amount

Understanding Debt Yield

Debt yield ratios provide lenders with a measure of risk that is independent of interest rates, amortization periods, and the market value of a property. A lower debt yield is indicative of higher leverage and, by extension, higher risk. Alternatively, a higher debt yield indicates lower leverage and, thus, lower risk. The debt yield is a much more accurate way for lenders to ensure a loan amount isn’t subject to inflation caused by low market cap rates, low interest rates, or high amortization periods. Debt yield is a frequently utilized metric when comparing risk between loans.

What is a good debt yield?

As with many factors surrounding commercial real estate finance, whether or not a debt yield can be considered good largely depends on the property type, the state of the market and current economy, the financial strength of tenants, etc. Even so, the minimum acceptable debt yield for most situations is 10%.

Debt Yield vs. Loan-to-Value Ratio

Traditional commercial real estate loan underwriting usually requires the use metrics such as the loan-to-value, or LTV, ratio. However, the problem with relying only on metrics such as LTV and DSCR is that they are often subject to manipulation and volatility. Fortunately, a debt yield ratio is a static measurement that is unaffected by changing market valuations, interest rates, and amortization periods.

LTV is arguably the most commonly used metric in commercial real estate transactions, and is a measure of the total loan amount divided by the appraised value of the property. When calculating LTV, the total loan amount may not be subject to variation, but the estimated market value can be. 

This became readily apparent during the 2008 financial crisis. Property valuations began to sink at an astonishing rate, and affected properties became difficult to value. This event was a tough reminder that market value is volatile and only an estimate, and that the loan-to-value ratio cannot always provide an accurate measure of risk taken on by a lender. An appraisal is extremely useful for nailing down a single probable market value, but in all actuality, the probable market value typically falls within a range and can be subject to volatility over time. 

Debt Yield vs. Debt Service Coverage Ratio

Another key metric used in traditional commercial real estate loan underwriting is the debt service coverage ratio, or DSCR. This figure is calculated by dividing a property’s NOI by its annual debt service. At first glance, it is easy to assume that the total debt service represents a static figure, but the DSCR is also easily manipulated. Simply lowering the interest rate used in the mortgage calculation and/or changing the length of the amortization period for the loan is enough to cause notable variance between DSCR calculations. For example, if the offered loan amount doesn’t meet the required 1.25x DSCR with a 20 year amortization schedule, then increasing the amortization to 25 years would be an option that would increase the DSCR. Practices such as these also increase the risk of the loan, but are not reflected when lenders use the DSCR or LTV on their own.

Debt Yield & CMBS Loans

CMBS lenders put a great deal of stock in the debt yield ratio metric. This may be attributed to the fact that most conduit lenders took substantial losses during the real estate bubble of 2008 after relying on metrics like LTV, which fell sharply as property values rose. The oversight caused them to over lend by significant amounts, leaving many lenders bankrupt, closed, and shuttered after the bubble burst. In addition, nearly all conduit loans are nonrecourse, meaning a CMBS lender generally can’t go after a borrower’s personal assets to recoup losses on a defaulted note.

Conclusion

While DSCR and LTV have generally always been used to determine risk in underwriting commercial real estate loans, the debt yield ratio can provide an additional measure of credit risk that is unaffected by variations in market value, amortization periods, or interest rates. These factors are all critical inputs in the calculation of LTV ratios and DSCR, but can be vulnerable to manipulation and volatility. A debt yield ratio, on the other hand, only uses a property’s net operating income and total loan amount in its formula, resulting in a static measure of credit risk, regardless of other fluctuating factors.