In commercial real estate lending (CRE), we often use several calculations to measure the leverage and risk of the transaction. One of the most common is a simple loan to value (LTV) calculation where the loan is divided by the value to get a percentage. A 50% LTV would mean that half of the CRE is funded by debt and the other half by equity. Another measurement is the debt service coverage ratio (DSCR). Here the annual net operating income (NOI) is divided by annual debt payments. If you had a company with a DSCR of 1.00, indicates that the company just earns enough NOI to cover its debt payments. This company will have nothing left over in the year after all expenses and debt payments are made.
Another measurement of leverage on a property is the debt yield. This is not as well known as a typical LTV or DSCR. The Debt Yield Ratio is calculated by taking the NOI and dividing it into the first mortgage debt balance. As an example, let’s say you have an office building with a NOI of $500,000 and the borrower wants to finance a loan of $6,000,000 on it. The transaction will have a Debt Yield Ratio of 8.33%. What is a way to think of what this means? Basically, if you were to foreclose on the property on day one of the loan, you would earn 8.33% annually as a cash-on-cash return on its money.
Now it is important to see what items are not include in the Debt Yield. Items like the cap rate or discounted cash flow analysis which would be used to establish value in the LTV ratio is not a factor here. The lender’s interest rate and loan amortization used to calculate the annual debt service is also not used here as it would be in the DSCR. The only factor here is the principal balance of the debt compared to the NOI of the property. This calculation helps take out the factor that a low cap rate, low interest rate, and high leverage would play in the analysis. At times in the market when these factors were present, real estate values were pushed to the stratosphere.
Most money center banks and CMBS lenders that are originating some form of longer-term fixed rate, conduit-style commercial loans are using the Debt Yield in their analysis. Few credit unions and community banks originating for their own portfolio look at this ratio. This does not mean that the ratio has no significance; it can be used as an important tool in measuring the leverage on a property.
There are some weaknesses in the ratio. Widely fluctuating NOI would be one factor. If you sized a loan based upon one-year analysis of NOI which spiked, you could be over-leveraging the property. It is also better used for CRE than a C&I or agricultural loan. Also note that acceptable Debt Yields will increase as the rate on alternative investments rise. Finally, just as no ratio should be used in a vacuum, neither should the Debt Yield.
What is a good Debt Yield? Like all other answers in lending, it depends. Acceptable Debt Yields will fluctuate between the property type and tenant. A good multi-tenant apartment or strong NNN leased credit tenant property in good market may have a debt yield as low as 9% and in some very rare cases, in the mid 8% range. Most other common types of CRE would have a Debt Yield of 10% that is acceptable. Some types of real estate that are more labor intensive if the lender were to take them back and operate them may have a higher threshold for the ratio.
If we use the example above and target a Debt Yield of 10%, the loan would need to be lowered to $5,000,000. If your institution were happy with a minimum threshold of 9%, the loan would be $5,550,000. A DY of 10% will produce an LTV in the 63-70% range. Pushing the DY down to 9% would raise the LTV to 69-77%.
The Debt Yield became more popular in the past decade. For over 50 years, CRE lenders used the DSCR as the main determining factor to size the loan. In the mid 2000’s, problems started to develop, bond investors had a strong appetite for CMBS, driving yields down. The result was CRE owners could obtain long-term fixed rate conduit loans in the 6% range. Dozens of conduits battled each other to win conduit loan business. Each promised to advance more money than their competitor, driving up LTV ratios into the low 80%. The CRE investor could achieve a historically high amount of leverage with a long-term fixed rate that was very low. Demand for this money skyrocketed as did demand for CRE. Cap rates on CRE plummeted.
When the crash hit, conduit lenders found that many of their loans were significantly upside down. Lenders began using the Debt Yield ratio to determine the correct size of a loan. This ratio can be a good tool in analyzing the risk of a loan request and the risk of a particular loan in your portfolio.