As a commercial real estate investor, it is helpful for you to know the potential debt yield ratio for the capital you are seeking. This profitability measurement will help you determine the approximate commercial real estate loan you could receive from a lender. Lenders will use the debt yield ratio to help lessen the risk involved when they advance capital by ensuring the ratio is typically no less than 10%.
The debt yield ratio calculates the rate of return a lender can expect to get by dividing the net operating income (NOI) by the first mortgage loan amount. The more the ratio dips below 10% the riskier the commercial loan becomes for the lender. The debt yield ratio represents the lender’s return on its money should the borrower default on the commercial loan and the lender is forced to foreclose on the commercial property. This ratio values both leverage and risk at the same time.
As a financial calculation, the debt yield ratio can be written as the NOI / 1st mortgage loan x 100. As an example, consider a commercial asset with an annual NOI of $540,000 where the property owner would like to receive a loan of $6,400,000. The debt yield ratio can be calculated by dividing $540,000 by the loan amount of $6,400,000 and multiplying that number by 100. This returns a debt yield of 8.4% which would create a risky advance by the lender based on the typical minimum of 10%.
By working through the numbers as in the example above, a commercial property owner can plan accordingly as to how much he or she might need to contribute to achieve the total capital needed for an investment. It should be noted that the debt yield will not take into consideration the commercial loan's interest rate, amortization time-frame, or the cap rate used to value the property. The primary factor the debt yield ratio will take into consideration is how big of a loan the commercial lender will advance in comparison to the NOI of the commercial property. Using the previous loan example, the lender will most likely only lend a first mortgage of $5,400,000 ($540,000/.10).
A 10% debt yield typically translates into a loan-to-value between 63% and 70%. The debt yield ratio helps the lender balance a value that may be inflated by low CAP rates, low interest rates and high leverage. It has become the ratio of greatest importance to many commercial lenders today. Minimum debt yields can vary by market and asset type. The more primary the market and less risky an asset type the more likely a lower debt yield will be acceptable.
Even though debt yield provides commercial lenders with additional data that removes subjectivity, lenders will continue to consider LTV and DSCR when determining the amount of capital they choose to advance. A lender’s primary goal will always be the return of their capital while at the same time minimizing the inherent risk involved. When you understand this as a commercial real estate investor, you will better understand why a lender will only offer a certain amount for a particular loan request.