The debt service coverage ratio (DSCR) and the loan to value (LTV) ratio have traditionally been used by lenders when underwriting commercial property loans.
But the debt yield is increasingly becoming more popular as a measure of risk, too—and many experts say that it’s much better. The only problem is that it is not yet as widely used as the other two metrics, so it’s often misunderstood.
In this blog, we’ll talk about what the debt yield is, how to calculate it, and why it is better than the LTV ratio and the DSCR.
Debt yield is a measure of risk that is not affected by factors such as the property’s market value, the interest rate on loan, or the length of the amortization period.
It is particularly useful for determining how risky a loan is and comparing risk relative to other commercial property loans.
When it comes to debt yield, you want a higher number. A higher debt yield indicates lower leverage—which ultimately means a lower risk. Conversely, a low debt yield indicates higher leverage and more risk.
Conventional commercial real estate wisdom recommends 10% as the minimum acceptable debt yield. However, the right number really depends on a number of property characteristics, such as the property type and strings of its tenants.
It also depends on the current economic conditions, the strength of the guarantors, and other such factors.
To calculate the debt yield of a property, simply divide its net operating income by the total loan amount.
For example, if a commercial property’s net operating income is $1,000,000 and the total loan amount is $10,000,000, then its debt yield would be:1,000,000 / 10,000,000 = 0.10 or 10%
Commercial property loan underwriters sometimes rearrange the debt yield equation to solve for the loan amount. In this case, the loan amount can be calculated by dividing the net operating income by the debt yield.
So if a bank requires a debt yield of 10% and a commercial property’s net operating income is $1,000,000, then the total loan amount would be $10,000,000 using this approach.
Commercial real estate lenders traditionally use the LTV ratio and the DSCR for underwriting. But the big issue with these two metrics is that they are quite easy to manipulate.
Debt yield, in comparison, is a static metric that is not affected by the length of the loan, the changing interest rates, or subjective market valuations.
The LTV ratio is calculated by dividing the total loan amount by the appraised value of the commercial property. The total loan amount in this formula is static, but the estimated market value is subject to manipulation.
Because market value is simply an estimate (it falls within a range) and tends to be volatile over time, the LTV ratio is not always an accurate risk metric.
The 2008 financial crisis showed the weakness of the LTV ratio. Valuations declined rapidly, and it became difficult to value distressed properties.
The DSCR is computed by dividing the net operating income by the annual debt service on a property. At first glance, the total debt service might seem like a static number in this formula, but the DSCR is actually easy to manipulate.
One can simply change the amortization period for the loan application or lower the interest rate that is factored into the loan calculation.
Let’s say that a bank requires a 1.25 DSCR for loans with a 20-year amortization period. If a proposed loan does not meet this minimum requirement, the amortization period could be increased to 25 years to increase the DSCR. Doing makes the loan a lot riskier—but you wouldn’t know it just by looking at the LTV or DSCR.
Let’s illustrate with an example. If the net operating income of a commercial property is $900,000 and its total debt service is $791,950, its DSCR at 20 years is 1.14.
It won’t meet the minimum DSCR required, which is 1.25.But if we adjusted the amortization period to 25 years, the debt service goes down to $701,510, and the DSCR reaches 1.28—good enough for the loan to be approved.
You might be wondering: Is the loan a good bet, assuming that the lender agrees to go with a 25-year amortization period? In this case, it is helpful to calculate the debt yield to make sure that the loan makes sense.
The debt yield is not affected by the loan’s amortization period, so it can provide a more objective measure of risk. To get the debt yield in this case, we simply divide $900,000 by $10,000,000, and the result is 9%.
If the lender requires a minimum debt yield of 10%, then this loan will not make it past underwriting even if the amortization period is manipulated. It’s worth noting that aside from the amortization period, the DSCR can also be affected by the interest rate.
Use the same example, and you will get a DSCR of only 1.05 at 7% interest. But change the interest to 5%, and the DSCR becomes 1.24. As you can see, the DSCR can be dramatically improved if the interest rate is lowered.
Both the LTV ratio and DSCR can be manipulated and affected by market conditions. If the market inflates values and lenders start competing on amortization periods and interest rates. loan requests that use these two metrics to measure risk can make it past underwriting—but they will become so much riskier should the market reverse its course.
The great thing about the debt yield is that it doesn’t rely on such variables, so it can provide a more standardized and more objective measure of risk.
If you’re interested in commercial real estate financing or would like to know what type of funding solution best suits your project, be sure to talk to a commercial property loan expert.
Such a professional can look at the different characteristics and factors that may affect your loan application and guide you on the best way to move forward.