How to Calculate The Debt Yield Ratio (2024)

The debt yield is becoming an increasingly important ratio in commercial real estate lending. Traditionally, lenders have used the loan to value ratio and the debt service coverage ratio to underwrite a commercial real estate loan. Now, the debt yield is used by some lenders as an additional underwriting ratio. However,since it’s not widely used by all lenders, it’s often misunderstood. In this article, we’ll discuss the debt yield in detail, and we’ll also walk through some relevant examples.

What is The Debt Yield?

First, what exactly is the debt yield? Debt yield is defined as a property’s net operating income divided by the total loan amount. Here’s the formula for debt yield:

How to Calculate The Debt Yield Ratio (1)

For example, if a property’s net operating income is$100,000 and the total loan amount is$1,000,000, then the debt yield would simply be $100,000 / $1,000,000, or 10%.

The debt yield equation can also be re-arranged to solve for the Loan Amount:

How to Calculate The Debt Yield Ratio (2)

For example, if a lender’s required debt yield is 10% and a property’s net operating income is $100,000, then the total loan amount using this approach would be $1,000,000.

What The Debt Yield Means

The debt yield provides a measure of risk that is independent of the interest rate, amortization period, and market value.Lower debt yields indicate higher leverage and therefore higher risk. Conversely, higher debt yields indicate lower leverage and therefore lower risk. The debt yield is used to ensure a loan amount isn’t inflated due to low market cap rates, low-interest rates, or high amortization periods. The debt yield is also used as a common metric to compare risk relative to other loans.

What’s a good debt yield? As always, this will depend on the property type, current economic conditions, strength of the tenants, strength of the guarantors, etc. However, according to the Comptroller’s Handbook for Commercial Real Estate, a recommended minimum acceptable debt yield is 10%.

Debt Yield vs Loan to Value Ratio

The debt service coverage ratio and the loan to value ratio are the traditional methodsused in commercial real estate loan underwriting. However, the problem with using only these two ratios is that they are subject to manipulation. The debt yield, on the other hand, is a static measure that will not vary based on changing market valuations, interest rates and amortization periods.

The loan to value ratio is the total loan amount divided by the appraised value of the property. In this formula, the total loan amount is not subject to variation, but the estimated market value is. This became apparent during the 2008 financial crises, when valuations rapidly declined and distressed propertiesbecame difficult to value. Since market value is volatile and only an estimate, the loan to value ratio does not always provide an accurate measure of risk for a lender. Consider the following range of market values:

How to Calculate The Debt Yield Ratio (3)

As you can see, the LTV ratio changes as the estimated market value changes (based on direct capitalization). While an appraisal may indicate a single probable market value, the reality is that the probable market value falls within a range and is also volatile over time. The above range indicates a market cap rate between 4.50% and 5.50%, which produces loan to value ratios between 71% and 86%. With such potential variation, it’s hard to get a static measure of risk for this loan. The debt yield can provide us with this static measure, regardless of what the market value is. For the loan above, it’s simply $95,000 / $1,500,000, or 6.33%.

Debt Yield vs Debt Service Coverage Ratio

The debt service coverage ratio is the net operating income divided by annual debt service. While it may appear that the total debt service is a static input into this formula, the DSCR can in fact also be manipulated. This can be done by simply loweringthe interest rate used in the loan calculation or by changing the amortization period forthe proposed loan. For example, if a requested loan amount doesn’t achieve a required 1.25x DSCR at a 20-year amortization, then a 25-year amortization could be used to increase the DSCR. This also increases the risk of the loan, but is not reflected in the DSCR or LTV. Consider the following:

How to Calculate The Debt Yield Ratio (4)

As you can see, the amortization period greatly affects whether the DSCR requirement can be achieved. Suppose that in order for our loan to be approved, it must achieve a 1.25x DSCR or higher. As demonstrated by the chart above, this can be accomplished with a 25-year amortization period, but going down to a 20-year amortization breaks the DSCR requirement.

Assuming we go with the 25-year amortization and approve the loan, is this a good bet? Since the debt yield isn’t impacted by the amortization period, it can provide us with an objective measure of risk for this loan with a single metric. In this case, the debt yield is simply $90,000 / $1,000,000, or 9.00%. If our internal policy required a minimum 10% debt yield, then this loan would not likely be approved, even though we could achieve the required DSCR by changingthe amortization period.

Just like the amortization period, the interest rate can also significantly change the debt service coverage ratio. Consider the following:

How to Calculate The Debt Yield Ratio (5)

As shown above, the DSCR at a 7% interest rate is only 1.05x. Assuming the lender was not willing to negotiate on amortization but was willing to negotiate on the interest rate, then the DSCR requirement could be improved by simply lowering the interest rate. At a 5% interest rate, the DSCR dramatically improves to 1.24x.

This also works in reverse. In a low-interest rate environment, abnormally low rates present future refinance risk if the rates return to a more normalized level at the end of the loan term. For example, suppose a short-term loan was originally approved at 5%, but at the end of a 3-year term rates were now up to 7%. As you can see, this could present significant challenges when it comes to refinancing the debt. The debt yield can provide a static measure of risk that is independent of the interest rate. As shown above, it is still 9% for this loan.

Market valuation, amortization period, and interest rates are in part driven by market conditions. So, what happens when the market inflates values and banks begin competing on loan termssuch as interestrate and amortization period? The loan request can still make it through underwriting, but will become much riskier if the market reverses course. The debt yield is a measure that doesn’t rely on any of these variables and therefore can provide a standardized measure of risk.

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Using Debt Yield To Measure Relative Risk

Suppose we have two different loan requests, and both require a 1.20x DSCR and an 80% LTV. How do we know which one is riskier? Consider the following maximum loan analysis for both loans:

How to Calculate The Debt Yield Ratio (6)

As you can see, both loans have identical structures with a 1.20x DSCR and an 80% LTV ratio, except the first loan has a lower cap rate and a lower interest rate. Withall of the above variables, it can be hard toquickly compare the risk between these two loans.However,by using the debt yield, we can quickly get anobjective measure of risk by only looking at NOI and the loan amount:

How to Calculate The Debt Yield Ratio (7)

As you can see, the first loan has a lowerdebt yield and is therefore riskier according to this measure. Intuitively, this makes sense because both loans have the same NOI, except the total loan amount for Loan 1 is $320,000 higher than Loan 2. In other words, for every dollar of loan proceeds, Loan 1 has just 7.6 cents of cash flow versus Loan 2 which has 10.04 cents of cash flow.

This means that there is a larger margin of safety with Loan 2, since it has higher cash flow for the same loan amount. Of course, underwriting and structuring a loan is much deeper than just a single ratio. There are other factors that the debt yield can’t consider such as guarantor strength, supply and demand conditions, property condition, strength of tenants, etc. However, the debt yield is a useful ratioto understand, and it’s being utilized by lenders more frequently since the financial crash in 2008.

Conclusion

The debt service coverage ratio and the loan to value ratio have traditionally been used (and will continue to be used) to underwrite commercial real estate loans. However, the debt yield can provide an additional measure of credit risk that isn’t dependent on the market value, amortization period, or interest rate. These three factors are critical inputs into the DSCR and LTV ratios, butare subject to manipulation and volatility. The debt yield on the other hand uses net operating income and total loan amount, which provides a static measure of credit risk, regardless of the market value, amortization period, or interest rate. In this article, we looked at the debt yield calculation, discussed how it compares to the DSCR and the LTV ratios, and finally looked at an example of how the debt yield can provide a relative measure of risk.

How to Calculate The Debt Yield Ratio (2024)

FAQs

How to Calculate The Debt Yield Ratio? ›

Debt Yield Ratio = Net Operating Income ÷ Total Loan Amount

How do you calculate debt yield ratio? ›

Debt Yield = Net Operating Income / Loan Amount

For example, consider the purchase of a property with $300,000 NOI and a loan of $3 million. In this example, the debt yield is 10 percent ($300,000 / $3,000,000 = 10%).

What is the formula for debt yield? ›

The formula to calculate the debt yield divides the net operating income (NOI) by the total loan amount. Where: Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses.

How to calculate DSCR from debt yield? ›

The DSCR is calculated by taking net operating income and dividing it by total debt service which includes both the principal and interest payments on a loan. A business's DSCR would be approximately 1.67 if it has a net operating income of $100,000 and a total debt service of $60,000.

What does a 10% debt yield mean? ›

The debt yield ratio is calculated by dividing a property's Net Operating Income (NOI) by the total loan amount. Consider a commercial real estate property with an NOI of $1,000,000 and a loan of $10 million. The debt yield in this case would be 10%, as the NOI is 10% of the loan amount.

How can I calculate my debt ratio? ›

To calculate your DTI, you add up all your monthly debt payments and divide them by your gross monthly income.

What is the formula for calculating debt ratio? ›

A company's debt ratio can be calculated by dividing total debt by total assets. A debt ratio of greater than 1.0 or 100% means a company has more debt than assets while a debt ratio of less than 100% indicates that a company has more assets than debt.

What is debt yield for dummies? ›

Debt yield is a simple calculation measured by taking the property's NOI and dividing it by the total loan amount. By examining this metric, lenders and investors can quickly and easily obtain an objective measure of risk with only the NOI and loan amount.

How do you calculate yield formula? ›

The calculation for yield differs depending on the type of yield. The common formula is income (eg from dividends or interest payments) divided by investment value. This can then be multiplied by 100 to get a percentage figure.

How do you calculate debt formula? ›

You collect all your long-term debts and add their balances together. You then collect all your short-term debts and add them together too. Finally, you add together the total long-term and short-term debts to get your total debt. So, the total debt formula is: Long-term debts + short-term debts.

What is a good cash flow to debt ratio? ›

However, a healthy ratio would generally fall between 1.0 and 2.0, with anything above 2.0 being considered very strong. This indicates that the company has more than enough operational cash flow to cover its total debt.

Is a high debt yield good or bad? ›

Investors should aim to have a higher debt yield than required to increase their chances of loan approval and negotiate better loan terms. A high debt yield indicates that the property generates sufficient income to cover operating expenses and debt service, making it a more attractive investment opportunity.

Is debt yield the same as interest rate? ›

The debt yield provides a measure of risk that is independent of the interest rate, amortization period, and market value. Lower debt yields indicate higher leverage and therefore higher risk. Conversely, higher debt yields indicate lower leverage and therefore lower risk.

How to calculate debt yield ratio? ›

Debt yield is one of the most important risk metrics for commercial and multifamily loans, and can be determined by taking a property's net operating income (NOI) and dividing it by the total loan amount.

What is a good debt yield for multifamily? ›

In this sense, a debt yield can be a better method to gauge the true risk of a loan, as well as to compare it to other loans on similar apartment properties. While debt yield requirements tend to vary, most lenders prefer debt yields of 10% or higher.

What is a good DSCR? ›

While a DSCR of 1.25 is the minimum requirement for most lenders, a higher number — such as 2 — shows lenders you are financially stable and can repay your debts. A higher DSCR can also mean a potentially lower interest rate as lenders see you as less of a risk for defaulting on your business loan.

How do you calculate yield ratio? ›

Yield ratio formula

Number of candidates results from the stage/number of candidates that passed through the stage = Yield Ratio. So, for example, the stages may be: The screening process to first interview or. Second interview to the final stage.

What is the formula for interest yield ratio? ›

The formula for a company's TIE number is earnings before interest and taxes (EBIT) divided by the total interest payable on bonds and other debt. The result is a number that shows how many times a company could cover its interest charges with its pretax earnings. TIE is also referred to as the interest coverage ratio.

References

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