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.  

 

 

When you embark upon a real estate project, lenders will require you to put up some of your own capital, the down payment,  before you can receive a loan. For example, if you want to fix-and-flip a $500K house, your typical hard money loan would require you to put down 40% ( $200K) in cash. Now suppose you want to reclaim the $200K before you’ve completed the project? You can use gap funding to, well, plug the gap.

 

Gap funding reduces or eliminates the cash you tie up in the down payment for a real estate loan. In other words, you can use gap funding to achieve 100% loan-to-value financing. The gap funder lends you an amount equal to some, or all, of your down payment. In return, the funder receives a cut (up to 50%) of the profit that you make on the project.

 

Advantages of Gap Funding

 

Here are some reasons to accept gap funding:

 

1. By freeing up your cash, you can participate in more projects at the same time. This can bulk up your profits and boost your company’s growth.
2. You can wrap the interest on the gap loan into the primary loan. For example, suppose you take a nine-month, interest-only fix-and-flip loan with an end-of-term balloon payment. If you get a gap loan, you can use some of it to prepay the first six months of interest on the original loan. If you arrange this in advance you might be able to score a lower interest rate on the original loan. In any event, this arrangement saves you from servicing the original loan for a period of time.
3. You and your gap funder share the risk. If you don’t make a profit on the project, the funder doesn’t get a profit kicker. 

 

Disadvantages of Gap Funding

 

Here are some reasons to eschew  gap funding:

 

1. You give up a portion of your profit. That might be OK, depending on the economics of the project.
2. Gap funding interest rates are higher than hard money loan rates. That’s to be expected, since the gap lender is in a junior lien position. 

 

When to Accept Gap Funding

 

The following situations are examples of situations where you might consider gap funding:

 

• Projects with a high potential profit margin.
• You need to conserve your cash.
• You want to wrap out-of-pocket interest payments into the gap loan.
• You need extra money to finish the project.
• It’s taking longer than anticipated to sell the property and you are still paying interest on the primary loan.
• You want maximum cash on cash return.

 

 

It’s easier than you might think to acquire an apartment building. You can fix and flip it, or keep it and enjoy long-term rental income. Here are five tips to help you with your acquisition.

Tip 1: Calculate the Income Potential

Begin by examining the building’s current rent roll. It lists all tenants, their monthly rent amounts and when their leases expire. From this, you can figure out your monthly and annual gross income. You’ll also know the number of vacant units, which establishes a ceiling on income potential. Combine this information with the current income statements to find the net operating income (NOI, which is income minus expenses). Knowing NOI allows you to formulate how much to pay for the property, which is the annual NOI divided by the required rate of return, known as the cap rate.

 

Tip 2: Use a Private Lender/Loan Broker

To make your purchase, you want the best financing possible, which means an affordable interest rate and a quick approval. Using banks is a tough slog, since you require a really good credit rating and a lot of patience. A much better alternative is to use a private lender, who works with a network of loan brokers. Competition within the network assures you will get the best deal possible. Your credit score is not that important, because the loan is based on the value of the property after rehab. If you live in the Greater Washington D.C. region, Specialty Lending Group is your go-to lender for unbeatable deals and knowledgeable service.

 

Tip 3: Forget About Government-Backed Loans

If you think bank loans are slow, imagine how much longer it takes for you to receive one backed by a government guarantee. Loan amounts might be capped below your requirements, and funding time can extend to half a year. That’s a long time for something to go wrong. You also must satisfy a large number of criteria to qualify for the loan. 

 

Tip 4: Understand Recourse Loans

A recourse loan is one in which you pledge your personal assets as additional collateral for the loan, above and beyond the apartment building itself. These are often required by lenders as protection against default. We always endeavor to offer you non-recourse loans, in which your personal property is safe. 

 

Tip 5: Use Interest-Only Loans for Fix-and-Flip

An interest-only loan will reduce your debt service outflows as you rehab the property. Once you sell the building, you pay off the loan with a balloon payment. If you decide to keep the building, you can refinance with a mini-perm or take-out loan.