Debt yield is of high importance to lenders, as it helps them to understand how long it would take for them to recoup their investment in the event of having to take possession of a property after a loan default.
What is Debt Yield?
Debt yield is the lender’s underwritten net operating income (NOI) divided by the loan amount. For example, if the required minimum debt yield is 10 percent and the project NOI is $500,000, the maximum loan amount would be $5 million.
A low debt yield requirement results in higher leverage and implies increased risk, while a high debt yield limits proceeds and implies less risk for the lender. Debt yield requirements are typically higher for bridge and construction loans than for permanent loans on stabilized properties.
What borrowers need to know
Debt yield is a static ratio that doesn’t vary with variables such as interest rate, amortization period, or cap rate. Therefore debt yield provides an objective measure of loan risk. A borrower seeking a loan with an insufficient debt yield ratio will fail underwriting, even with acceptable loan-to-value (LTV) and debt service coverage ratio (DSCR) numbers. In effect, debt yield safeguards against loans on riskier properties.
Debt yield calculation
Debt yield is calculated by taking a property’s NOI and dividing it by the total loan amount. For instance, if a commercial property’s net operating income was $200,000 and the entire loan amount was $1,500,000, the debt yield would be:
$200,000/$1,500,000 = 0.133 or 13.33%
Many multifamily lenders now require a minimum debt yield in order to approve a loan, so it’s also possible to calculate the maximum loan amount, as long as you know the annual income of a property. For instance, if, in the example above, a lender had a minimum debt yield requirement of 12%, a borrower would be able to take a loan out of up to $1.66 million (as long as that amount was consistent with other factors, like LTV and DSCR).
$200,000/0.12 = $1,666,666
To extrapolate, a debt yield of 12% would mean that it would take a lender about 8.3 years to recoup their losses, assuming they did not sell the property beforehand, NOI did not increase, and the borrower defaulted immediately.
Assessing repayment risks
To be sure, commercial real estate loan underwriting involves a much deeper assessment than financial ratio analysis, which does not take into account the borrower’s financial strength, tenant credit quality, property location, or the impact of competing developments (to name a few considerations).
However, lenders are increasingly deploying the debt yield in their underwriting, and borrowers need to clearly understand how the lender uses it early in the loan underwriting process in order to avoid surprises later.
We’re here to help
Investing in multifamily conversions of offices and hotels requires knowledgeable partners and informed decision-making. To ensure you’re making the best commercial real estate investment decisions for your goals, reach out to us at Asset Point Capital today.