23 Aug Use of Debt Yields in Commercial Real Estate Lending
What a debt yield measures
With the markets crashing and defaults at all time highs, some nonrecourse investors now look to measure their default risk with debt yields. In other words, they size loan amounts by the return on their debt should the property default. The debt yield therefore measures the lender’s risk on loan proceeds.
If the loan defaults on day 1, the debt yield is the cash on cash return the lender will get on the loan. For example, if the lender wants a 10% yield on its loan proceeds, it determines the loan amount by dividing the net operating income (NOI) by 10%. The NOI then has to equal a 10% yield on the amount of the first lien.
In other words, the debt yield is the NOI as a percentage of the loan amount. The higher the debt yield, the lower the lender’s risk. Conversely, the lower the debt yield, the greater the lender’s risk.
A worked example
For example, a lender offers a loan of $1,000,000 with an interest rate of 5.5% and 25 year amortization. The property has a 7% capitalization rate and a value of $1,400,000, with a Net Operating Income (NOI) of $98,000. The debt coverage ratio is 1.33 (NOI / annual debt service), and the LTV is 71% ($1,000,000 loan / $1,400,000 value).
The NOI divided by the loan amount provides a debt yield of 9.8% ($98,000 / $1,000,000 = .098 x 100%). However, if the lender requires a 12% debt yield, the loan amount would need to drop from $1,000,000 to $816,667 ($98,000 / .12).
Will debt yields become common?
Bank lenders do not commonly use the debt yield ratio at present. Still, it may become more common as lenders look for a way to mitigate the risk of loss in a volatile market.