Understanding Debt Yield and Why It is Important to Lenders

Debt yield is a simple metric used to determine the risk of a proposed loan. The formula is

Debt Yield = Net Operating Income (NOI)/ Loan Amount

While it is very easy to calculate, the lender must determine if the result is a worthwhile investment for them given the property type and market conditions. Generally, ten percent (10%) is considered the minimum Debt Yield for a loan. Essentially, the lower the Debt Yield the higher the lender’s risk.

Debt Yield is calculated independently of capitalization rates (“cap rate”), interest rates or amortization periods. It is a quick and easy way to assess the risk of a loan but is not the only criteria in analyzing a loan. Two other metrics for evaluating a loan are 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.

For example, DSCR can be adjusted to fit 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.  

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 be calculated as follows:

Debt Yield = Net Operating Income (NOI)/ Loan Amount

Debt Yield= $100,000/$750,000

Debt Yield= 13.33%

Debt Yield provides a lender a measure of risk independent of interest rate, as opposed to DSCR and LTV. Given the recent market conditions (pre COVID-19), where low interest rates and compressed cap rates were the norm, loan amounts determined solely by DSCR and LTV provided little comfort in a rising interest rate environment.   

Related: An Overview of the Visio Box, 5 Key Small Balance Commercial Loan Types