Three useful metrics for evaluating a commercial real estate loan are Debt Yield, Loan-to-Value (LTV), and Debt Service Coverage Ratio (DSCR). A proposed loan must be supported by Debt Yield and comply with LTV and DSCR requirements as determined by the lender.
Debt Yield vs. DSCR
Debt Yield has grown in favor as a metric of risk because it is easy to calculate and is independent of cap rates, interest rates, and amortization periods. In a low interest rate and compressed cap rate market, Debt Yield should be looked at, yet it is very hard to determine the risk of a loan.
DSCR can be massaged to fit into a lender’s “box” by changing the amortization period. In the table below, expanding the amortization period by five (5) years from 20 years to 25 years increases the DSCR from 1.15x to 1.22x. If the lender had a 1.20x DSCR requirement, that one small adjustment can make the difference in getting a loan done or not.
Small Adjustments Determine Whether or Not a Loan is Given
|
|
Scenario 1 |
Scenario 2 |
|
Loan Amount |
$ 750,000 |
$ 750,000 |
|
Interest Rate |
10.0% |
10.0% |
|
Amortization |
25 |
20 |
|
Loan PMT |
$81,783 |
$86,852 |
|
DSCR |
1.22x |
1.15x |
|
Debt Yield |
13.33% |
13.33% |
The adjustment to the amortization period does not impact the Debt Yield. In the example (assumes NOI of $100,000, a 10% cap rate and 75% LTV) above the Debt Yield would not be impacted by the change to the amortization period.
Similarly, small changes in the cap rate used to determine the value of a cash flowing asset can move the needle and affect the LTV. As we can see in the example below, a 25-bps change in cap rate takes the Debt Yield from 10% to 9.67% (remember in a previous blog post on Debt Yield 10% is typically considered the minimum for lenders).
|
|
Scenario 1 |
Scenario 2 |
|
NOI |
$ 100,000 |
$ 100,000 |
|
Cap Rate |
7.50% |
7.25% |
|
Value |
$ 1,333,333 |
$ 1,379,310 |
|
Max LTV |
75% |
75% |
|
Loan Amount |
$ 1,000,000 |
$ 1,034,483 |
|
Interest Rate |
6.0% |
6.0% |
|
Amortization |
25 |
25 |
|
Loan PMT |
$77,316 |
$79,982 |
|
DSCR |
1.29x |
1.25x |
|
Debt Yield |
10.00% |
9.67% |
In this situation, the lender would have to lower the LTV to offset the change in the value of the property and to bring the Debt Yield back to 10%.
Determining The Risk of a Commercial Loan
As you can see in these examples, small (potentially subjective) changes in factors that determine the LTV and DSCR can take a loan from a doable deal to a non-starter. While Debt Yield is a great tool, many other factors go into underwriting commercial real estate loans, but the three tools presented here are considered the primary metrics in determining overall risk of a loan.
