Did You Know?Traditionally, the debt service coverage ratio was utilized as the ratio for loan for commercial estates by lending institutions. However, the debt yield ratio has increasingly become popular, and is being used instead of the traditional ratio, especially by lenders in CMBS1 market.
Yield refers to 'return' on any kind of investment, and any investor, before investing, would want to calculate the size of his returns. Similarly, 'debt yield' is a terminology commonly used in real estate, wherein the yield on debt is calculated by comparing the size of loan amount with the NOI (i.e. Net Operating Income) of the investor, i.e, should the investor default, how much can the lender foreclose2
the estate for.
It is one of the risk mitigation techniques used by lenders, especially, the conduit lenders3
. Lower the yield, higher the risk. This formula does not consider the interest rates, cap ratio, etc., which traditional lenders use.
How to Calculate Debt Yield
The formula for debt yield can be stated as follows:
Note that this formula is for a first mortgage loan, since many commercial estate loans now involve mezzanine financing4.
|Net Operating Income||X 100|
|Amount of the Mortgage Loan|
Suppose, Net Operating Income = USD 105,600
Mortgage Loan amount proposed to be given = USD 1,000,000
Thus, the debt yield = 105,600 / 1,000,000 = 10.56%
Thus, the lender enjoys a yield of 10.56% in case the borrower defaults for the first payment.
How to Calculate Net Operating Income (NOI) of a Commercial Estate
NOI of a commercial estate is the annual income generated (such as rent) by the commercial estate, after deducting operating expenses such as taxes, repairs and maintenance, utilities, etc.
Minimum Debt Yield Ratio
Of course, higher the yield, more the lender will consider investing in the commercial estate. The tendency of investors is to expect a minimum debt yield ratio of approximately 10%. However, it can vary as per different factors, such as the area of the commercial property, market and economic conditions, risk quotient, etc. There have been reports of the minimum debt ratio being lowered to around 8.5 to 9% considering the current market scenario.
This ratio is not yet adopted by banks that still rely on the debt service coverage ratio; however, it has become a popular tool for conduit lenders in the CMBS industry. However, many in the lending business of commercial property have started adopting this technique.
1CMBS: Commercial mortgage-backed securities
As the name suggests, these securities are issued against the mortgaged commercial properties. They can be sold publicly or privately by the conduit lenders.
It implies the legal right of selling off the mortgaged or pledged property by the lender in case of default of payments by the borrower.
These lenders are responsible for the securitization of the loans backed by mortgaged commercial property assets, and selling them as investments in the CMBS market.
This type of financing gives the lien holder the right to the stocks of the company instead of right over property. This type of financing was introduced to bridge the gap between the borrowed amount and the financing requirements.
The commercial estate market is usually volatile and ever-changing. Debt yield ratio breaks the traditional approach of lending market, and the underwriters try to measure the performance of their investment through the risk of default.