How to calculate debt yield in commercial real estate

What is debt yield in commercial real estate?

Debt yield measures how much annual income a property produces relative to the debt against it. Expressed the other way round, it is the return a lender would earn on its loan if it foreclosed and took ownership at the current balance. A 10% debt yield means the property's income would repay the loan in ten years with no rent growth, no appreciation and no sale.

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.

The debt yield formula

The debt yield formula is net operating income divided by loan amount. Both inputs are verifiable: NOI comes from the property's financials and the loan amount comes from the term sheet. Neither depends on an appraisal or on the interest rate, which is why debt yield is harder to manipulate than loan-to-value or debt service coverage.

The calculation for Debt yield = Net Operating Income (NOI) / Loan amount

One point worth being precise about: many institutional lenders underwrite debt yield on net cash flow rather than NOI, deducting capital reserves first, which produces a slightly lower figure. If you are checking a number against a term sheet, confirm which one the lender is using. For the components that make up the numerator, see our breakdown of net operating income in commercial real estate.

How to calculate debt yield: a worked example

Calculating debt yield takes two inputs and one division. The example below uses a property producing $1,000,000 in annual net operating income against a requested loan of $10,000,000. The same three steps apply to any property regardless of size, asset class or the terms of the loan being requested.

• Step 1. Establish the property's annual net operating income. Revenue less operating expenses, before capital expenditure and debt service. Here, $1,000,000.

• Step 2. Take the total loan amount from the term sheet. Here, $10,000,000.

• Step 3. Divide NOI by the loan amount and express it as a percentage. $1,000,000 / $10,000,000 = 0.10, or a 10.00% debt yield.

The calculation also runs in reverse, which is how lenders actually use it. If a lender applies a 10% minimum debt yield to the same property, the largest loan the income supports is $1,000,000 divided by 0.10, or $10,000,000. Raise the required debt yield to 12% and the maximum loan falls to $8,333,333 on identical income.

What is a good debt yield in commercial real estate?

Most lenders set a minimum debt yield somewhere between 8% and 10% for stabilized commercial properties. CMBS and conduit lenders typically sit at the top of that band, around 10% or higher. Agency lenders on multifamily will often accept 8% to 9%, and life companies lending on prime assets sometimes go lower still. Higher debt yield means lower risk to the lender.

These are market conventions rather than fixed rules, and the floor moves with property type, market, asset quality and the lender's own appetite. Transitional and value-add assets carry higher minimums than stabilized ones. Smaller community banks and credit unions often do not use debt yield as a primary metric at all, leaning on DSCR and LTV instead.

The practical point for a borrower is that the debt yield floor increasingly sets the loan amount before anything else is negotiated. On many CMBS and life company term sheets the deal is sized to clear the debt yield test first, and the resulting LTV simply falls out of that. If your loan request assumes post-acquisition rent growth to clear the floor, expect the loan to be sized on trailing income instead.

Debt yield compared with LTV and DSCR

LTV depends on an appraised value. DSCR depends on the interest rate and amortization schedule. Debt yield depends on neither. The same $10,000,000 loan on $1,000,000 of NOI holds a 10% debt yield whether the rate is 4% or 7%, while the DSCR on that loan would swing widely. That stability is why lenders adopted it as a floor test.

Loan-to-value (LTV)

The calculation for Loan-to-value = Amount of mortgage loan / Value of the property

Debt service coverage ratio (DSCR)

The calculation for Debt service coverage ratio = Net operating income / Debt service

Read together, the three metrics answer different questions. LTV asks how much of the property's value is financed. DSCR asks whether current income covers the payment. Debt yield asks how quickly the income alone would return the lender's principal. A loan can clear two of the three and still fail on the third, which is why lenders run all of them.

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. That relationship, and the other approaches it sits alongside, is covered in our overview of the major CRE valuation methods.

Market value = Net operating income / 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. For how borrowers are managing that balance across whole portfolios in the current rate environment, see our piece on regaining control of debt in a volatile market.