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By Altus Group | August 28, 2020

Many real estate practitioners are familiar with the loan-to-value (LTV) ratio and the debt service coverage ratio (DSCR), but fewer are familiar with the use of the debt yield (DY) ratio to underwrite loans for commercial real estate. For a comparison, see the formulas below with a description and an example of how the LTV, DSCR, and DY are calculated.

Loan-to-Value (LTV) = Amount of mortgage loan / Value of the property

Property value = \$15,400,000
Mortgage loan = \$10,000,000

65% = \$10,000,000 / \$15,400,000

Debt Service Coverage Ratio (DSCR) = Net Operating Income (NOI) / Debt Service

Net Operating Income = \$1,000,000
Debt service = \$700,000

1.43 = \$1,000,000 / \$700,000

Debt Yield (DY) = Net Operating Income (NOI) / Loan amount

Net operating income = \$1,000,000
Loan Amount = \$10,000,000

10.0% = \$1,000,000 / \$10,000,000

While it’s pretty clear how LTV and DSCR relate to the operation of the property, it’s typically less clear to those new to real estate what the debt yield tells a lender. You can also look at the debt yield as the return that the lender would receive if it had to take possession of the property. And just like LTV and DSCR, the debt yield will change over time depending on how the property performs.

## Why Not Just Use LTV and DSCR?

For many years, lenders relied on the LTV and DSCR to size loans on commercial real estate. So why develop a new metric if the previous methods were working just fine? To really understand why debt yield is different and why lenders have begun to consider it when making loans, we need to walk through a few examples. Bear with us as we walk through this slowly. There are quite a few inputs that need to be considered to set up the scenario in which the differences become obvious.

## Assumptions

Before we start, we should review some of the basics of property valuation and lending. Recall that the value of a property can be estimated by dividing the NOI of the property by an appropriate market cap rate.

Market Value = NOI / Cap Rate

That was easy enough. Now we need to figure out how much a lender is willing to loan on a property. Let’s first look at the traditional metrics of LTV and DSCR to illustrate the limitations. In order to do this, we need to add a few more metrics into the mix. This time we’ll include the market LTV and DSCR. Similar to interest rates and cap rates, the market typically sets levels for the LTV and DSCR that a lender is willing to accept. For the LTV, this range is usually between 60% and 70%. The DSCR has a lower bound limitation of around 1.25. It’s important to note that the LTV and DSCR both vary by property type and class, but a deeper discussion of the ranges is beyond the scope of this paper.

The table below walks us through an analysis of the valuation, loan amount and payment for a commercial property in a low cap rate market. For the LTV, we’re assuming a market level of 60%, resulting in a loan amount of \$12,000,000. Then applying a 5.25% mortgage rate and a 25-year amortization, we get an annual payment of around \$863,000. So far this looks ok. However, the DSCR on \$1,000,000 of NOI with an \$863,000 annual payment is only 1.16, which is very low and probably below what a lender will require to make the loan.

Alternatively, the table below walks through the analysis of a property in a high cap rate market. In this scenario, we’ll reverse the analysis and look first at the DSCR constraint. Here we see that the market is requiring a minimum of a 1.40 DSCR. Using the NOI of \$1,000,000 and the DSCR of 1.40, we can back into the maximum payment allowed of \$714,286. Applying the same loan metrics as above, a 5.25% loan interest rate and a 25-year amortization schedule, we find that a payment of \$714,286 will support a loan amount of \$9,933,089 (using a present value formula). This seems ok until you look at the LTV that results from a loan of \$9,933,089 on a property that’s valued at \$12,500,000 in this market: 79.46%. This is most likely much higher than a lender would be willing to accept on a loan.

The scenarios above show the effect that wide variations in cap rates can have on the lenders decision of how much to loan. In contrast, the tables below show the result of sizing a loan based solely on a debt yield limitation. In this case, the debt yield is set to 10.0% (recall that the debt yield is determined as the NOI / loan amount). The table on the left values the property using a 5.0% cap rate and the table on the right uses an 8.0% cap rate for the valuation. As you can see, the loan in both scenarios is limited to \$10,000,000 regardless of the value of the property and is independent of the effect the cap rate has on the valuation of the property.

## Sizing a Loan Using the LTV, DSCR, and Debt Yield

The scenarios illustrating the use of the LTV, DSCR, and Debt Yield above are very simplistic and were meant to highlight some of the extreme differences that can be seen under various circumstances. In the real world, lenders consider all three metrics and typically size the loan based on the lower amount of the three approaches, although there is room for modification based on factors such as the quality of the property, quality of the borrower, etc.

Many people ask why lenders don’t just require low LTV’s and high DSCR’s on the loans they make. Lenders would probably favor a world where that’s the case, but many borrowers tend to want higher leverage in order to boost equity returns. Today, there are hundreds, if not thousands, of commercial real estate lenders. Lenders need to balance the risk of making a loan with being competitive in the market. Thus, there is a constant push and pull between these metrics to try to achieve an optimal outcome for both lenders and borrowers.

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