Understanding Debt Yield in Commercial Real Estate Investing
Debt yield is a method of measuring risk for commercial real estate lenders. In short, it looks at the net operating profit (NOP) of the property and uses this to determine how long it will take to recoup their losses if the borrower defaults on the payments
Some, but not all, lenders prefer this metric when deciding whether to grant a loan.
Debt Yield in Real Estate: The Main Points to Understand
- What is debt yield?
- Calculating debt yield
- Other important real estate investment metrics
What is debt yield?
Debt yield is an alternative method of assessing loan risk that relies on calculating the NOP against the money borrowed. This gives the lender an accurate impression of how long it would take to get its money back in the case of foreclosure.
Unlike more traditional lending options, debt yield doesn’t consider affordability parameters, such as the:
- Market value of the property.
- Amortization periods.
- Interest rates.
- Annual debt service.
While debt yield calculations aren’t used by every lender, its use is becoming more widespread. This is because it provides a risk assessment that’s far less likely to be manipulated by external influences.
When it comes to calculating the level of risk, the lower the debt yield, the higher the leverage and associated risk for the lender. Conversely, a higher debt yield equals a lower lending risk.
Calculating debt yield
To calculate debt yield, the NOI is divided by the loan amount. An example would be a $6,000,000 loan with a $600,000 NOI, which equals a 10% debt yield. Traditional lenders generally have a minimal debt yield that’s considered viable at somewhere around the 10% mark. This is, of course, subject to other assessments and risk factors.
However, some lenders will negotiate borrowing with a debt yield as low as 8% or even 7%. However, this represents a higher risk and comes with associated higher interest rates. Cautious borrowers often try to keep debt yield at 12% or above—and this also means more favorable interest rates. Those prepared to take a higher risk (and thus, a higher potential profit) might be happy to borrow closer to the lower end of the equation.
Other real estate investment metrics
The reason some lenders prefer debt yield over other real estate investment metrics is that no matter what happens to the financial and property markets, dramatic swings in value are rare. This is in direct contrast to loans, such as debt-service coverage ratios (DSCR) and loan-to-value (LTV).
Another metric is the capitalization rate (more commonly shortened to cap rate). This is calculated by dividing the NOI by the market rate of the property. The cap rate is also susceptible to outside influences and real estate boom and bust.
These three mainstream lending examples are extremely sensitive to the swings of the financial markets. A loan secured on debt yield, however, is far less likely to leave a lender at the mercy of changing market conditions.
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