Debt yield is a measure of the risk associated with a loan. It supplements other familiar metrics, including debt service coverage ratio and loan-to-value ratio. In some cases, a borrower will be turned down for a CRE loan if the debt yield is too low, although debt yield is less important for hard money loans.
The formula for debt yield is:
Debt Yield = Net Operating Income / Loan Amount
Note that debt yield is not affected by variables such as cap rate, amortization period or interest rate.
The components of debt yield are:
- Net Operating Income (NOI): This is the remainder after subtracting operating expenses from a property’s gross revenue. It excludes tax and interest expenses, but includes depreciation and amortization, which are non-cash expenses. Some lenders like to use EBITDA (earnings before interest, taxes, depreciation and amortization) as the numerator instead of NOI, because it indicates the actual cash flows available to repay the loan.
- Loan Amount: This can be almost any type of property-related loan, including bridge, construction, refinancing or mortgage loans. Mezzanine loans do not affect debt yield.
Calculating Debt Yield
Let’s work a simple illustration; You want a $1 million loan on a multi-family property that you want to purchase and hold for income purposes. It generates $90,000 in annual NOI. The property appraises for $1.4 million and you are willing to put in a down payment of $400,000. The debt yield on the property is $90,000 / $1 million, or 9%. If the lender’s minimum debt yield is 10%, you’ll have to kick in additional equity to reduce the size of the loan. If you increase your down payment to $500,000 instead of $400,000, the loan amount falls to $0.9 million and the debt yield jumps to 10% (that is, $90,000 / $0.9 million).
We can check how debt yield caps the loan-to-value amount. Assume the lender will offer a loan with a LTV ratio up to 65%. The original loan had an LTV of 71.4% (i.e., $1 million / $1.4 million), which is too high. The revised deal’s LTV is 64.3% (i.e, $0.9 million / $1.4 million), which is low enough to satisfy the lender.
Debt Yield Usage Today
A 10% debt yield requirement is pretty standard. However, given the current high demand for mortgage-backed securities (MBS), you might find loans with a required debt yield of 9% or lower from conduit lenders.
The hotter the market, the lower the debt yield requirements. For example, Denver has Class A apartment loans with a debt yield of 7.5%, and downtown offices require 8.5%. Normally, required debt yields are smaller for less-risky real estate in top markets.
As indicated, satisfying a debt yield is less important in the private lending context. At SLG, we provide loans at 65% LTV, irrespective of debt yield.