Debt Yield: What Is It & Why Is It Important?

June 23, 2022
4
min

When investors and lenders think about debt financing and the risks associated with making mortgage payments, they typically focus on LTV (Loan-to-Value, or the loan amount divided by property value) and debt service coverage ratio (DSCR, or the NOI divided by the annual debt service) when sizing a new loan. There’s typically a maximum LTV (~70-80%) and minimum DSCR (~1.25x) that a loan needs to meet in order to be “approved”, and for the property to produce sufficient cash flow to pay the mortgage and provide an investment return to the investor. Both of these metrics are great and incorporate the property’s value and NOI, as well as the loan amount and terms, such as interest rate and amortization. There is however another metric that some lenders use when sizing a new loan.

Debt Yield: What Is It & Why Is It Important?

Debt yield is a simple calculation and is measured by taking the property’s NOI and dividing it by the loan amount. You can think of it as the “cap rate” on the loan amount.  

For example, if a property has an NOI of $100,000, and a loan amount of $1,000,000, the debt yield is 0.10 or 10% ($100,000 / $1,000,000 = 0.10 or 10%). If the loan amount is increased to $1,100,000, the debt yield falls to 9.09% ($100,000 / $1,100,000 = 0.909 or 9.09%). If the NOI increases to $110,000 and the loan amount stays at $1,000,000, the debt yield increases to 11% ($110,000 / $1,000,000 = 0.11 or 11%).  

As we can see in the chart below, the debt yield increases when the NOI increases and/or when the loan amount decreases, and the debt yield decreases when the NOI decreases and/or when the loan amount increases.

Debt yield is measured as a percentage and can be thought of as the property’s percentage of income (yield) based on the loan amount. From a lender’s standpoint, it can be thought of as the yield or income that the lender will receive based on their investment (the loan amount) if they have to take over the property, typically through a foreclosure.

Lenders focus on the “going in” debt yield, meaning ‘what will the debt yield be in year 1 using the year 1 NOI and initial loan balance’. Over time, the actual debt yield can fluctuate as the property’s NOI can move up or down and the loan amount typically decreases as principal is paid down.

Debt yield can be thought of as the loan’s cap rate where the NOI is divided by the loan amount vs. the property’s cap rate where the NOI is divided by the property value or purchase price.  Provided the loan amount is lower than the property’s value, Debt yield will always be higher than the cap rate since we’re taking the same numerator (NOI) and dividing it by a lower denominator (loan amount vs. property value).

Is It Better to Have a High or Low Debt Yield? 

Well, it depends. A lender wants as high a debt yield as possible as this will give them more comfort because there is more income to support their loan. Lenders will typically have a minimum debt yield (say 6-8%) for less risky and more stable properties, such as multifamily, while requiring a higher debt yield (8-10%+) for more risky and less stable properties such as hospitality.  

Debt yield also depends on macro factors and global events. As we saw during the pandemic, many offices shut down operations for several months or even years; consumers stopped going to shopping centers, restaurants, and malls, and many travelers stopped staying in hotels.  These asset types (office, retail, and hospitality) became riskier assets as there was less certainty of sufficient NOI to cover debt service, so lenders increased their minimum debt yield when extending new loans collateralized by these asset types.

Debt yield is also unique in that it removes the impact of interest rates and amortization schedules as is the case with DSCR (Debt Service Coverage Ratio). With DSCR, the debt service is determined by the loan amount, interest rate, and amortization schedule. The higher the interest rate or shorter the amortization, the higher the debt service, and keeping NOI the same, the lower the DSCR. Investors will need to boost NOI to maintain a sufficient DSCR when debt service increases.

Impacts to Debt Yield

With debt yield, there is no debt service so interest rates and amortization schedules have zero impact on debt yield.  

So, why is this important? Some lenders, typically non-recourse lenders such as Agency and CMBS lenders, focus on debt yield as a way to size a loan. These lenders often have minimum debt yields for loan size (the larger the loan size the lower the allowable debt yield), asset type (typically the less risky an asset type the lower the debt yield), location (the less risky the location the lower the debt yield), and other factors. Essentially, lenders will have a lower debt yield for less risky properties as there is a lower likelihood of a property defaulting on their mortgage payments. However, on the flip side, if a lender has to take over a property that has a lower debt yield, the lender will receive less income from that property, so in their eyes sometimes a lower debt yield can be viewed as a riskier lending investment.

During times of rising interest rates (as we’re experiencing today), higher interest rates result in increased annual debt service so most lenders will increase their minimum debt yield to anticipate additional NOI that is needed to support higher debt service in the future based on the same loan amount. If the NOI stays the same, the lender will need to reduce the loan amount to meet a higher minimum debt yield.

Conversely, during times of decreasing interest rates, lenders will typically lower their minimum debt yield as they expect future debt service to decrease and there’s room for a lower NOI or higher loan amount.

In today’s current environment, with interest rates increasing, investors should expect lenders to increase their minimum debt yield requirements in anticipation of increased interest rates. That means multifamily investors that were used to lenders approving loans at 6-8% debt yields will likely need to be at 8-10% debt yields, and those that are investing in riskier assets such as retail, office, or hospitality might expect lenders to have minimum debt yields in the low double digits.

Overall, debt yield is a metric that should be monitored when underwriting a new investment property. Most conventional lenders such as banks and credit unions focus on LTV and DSCR, however, as we mentioned earlier, there are lenders out there that focus on debt yield so investors should be aware of how to calculate debt yield and how the property’s debt yield compares to a lenders minimum debt yield requirement.

StackSource is a tech-enabled commercial real estate loan platform. We connect investors who are developing or acquiring commercial properties with financing options like banks, insurance companies, and debt funds through a transparent online process. We’re taking the best of commercial mortgage brokerage and updating it for the 21st century. Learn more at StackSource.com.