How to Calculate the Debt Yield Ratio

The modern lending market has diversified heavily in the last 10 years and lenders are invoking new ways to calculate risk, including debt yield ratios.

Debt yield ratios are one such lesser-known metric used to calculate the risk involved in commercial real estate lending. Debt yield combines with the Loan-to-Value Ratio (LTV) and Debt Service Coverage Ratio (DSCR) to evaluate and compare loans and mortgages.

The debt to yield ratio divides the net operating income of the property by the loan amount.

This provides a measure of risk independent from the property value, amortisation or interest rates – it focuses on net property income or annual revenue instead.

When it comes to property lending and mortgages, loan-to-value (LTV) has always traditionally dominated the conversation, and likely plays the biggest role in the lender’s underwriting procedures.

However, LTV revolves around an increasingly volatile variable: property value. LTV calculations rely on the valuation of the property itself which can be slow to update or react or may outpace growth.

Debt to yield proves more robust in some circumstances where LTV and DBCR are easily manipulated.
 

How to Calculate the Debt Yield Ratio

The debt yield ratio, or debt to yield ratio, is straightforward to calculate.

Debt yield = loan amount/operating income.

So, say a building’s annual operating income is £100,000.

The total loan is £1,000,000

Debt yield = 1,000,000/100,000 = 10

The debt yield ratio here is 10%

Lower debt to yield ratios creates higher risk, as the property’s net operating income is lower relative to the required loan.

Higher debt yields equal lower risk, as the property’s net operating income is higher relative to the required loan.

Lending a smaller amount on a building with a higher net operating income is less risky for the lender.

As a commercial property investor, this provides you with a means of weighing up the different loans and financing instruments available.

You want to find a lender willing to provide you with a fair loan relative to the risk of the debt yield ratio.
 

Debt Yield vs Loan to Value Ratio

LTV’s limitations are greatest when value is fast-fluctuating, and this includes when the property value is increasing as well as crashing, e.g. during a financial crisis. Anything that makes the property difficult to value erodes the robustness of LTV.

Whilst a commercial property valuation is likely relatively accurate, it still falls within a fluctuating, volatile range.

Contrastingly, debt yield’s focus on operating income liberates it from the volatility of value used to calculate LTV. Of course, debt yield introduces its own challenges in asserting that the operating income value itself is correct and will remain consistent in the future.

But, for commercial buildings with long-term net operating data, debt yield ratios are robust and form a risk assessment independent from market value, amortisation or interest rate fluctuations.

Debt yield is also useful as a comparative measure. For example, by analysing the trends in debt yields throughout the last 20 years or so, you can evaluate how risky lending became at any given period across and sector or industry and why.

You can ask and answer questions like, “what debt yields were lenders prepared to extend down to, and how did this impact their financials?”

PropertyWeek states that City office ‘prime’ yields fluctuated between a low of around 4.5% and a peak of around 6.5% over the last 20 years. If debt yields were then anticipated at around 6.5%, this would provide confidence that even if the market becomes extremely disrupted and distressed, lenders should still be able to exit their position.
 

LTV VS Debt Yield Table

The below table shows LTV values for a £1,500,000 loan for a building with the same £95,000 net operating income. The cap rate and market value could both fluctuate within the given range, thus altering the LTV.

This is compared to the same building’s debt yield ratio. You can see how altering many variables produces different LTVs where debt yield remains static.
 

LTV
Loan Amount £1,500,000 £1,500,000 £1,500,000
Net Operating Income £95,000 £95,000 £95,000
Cap Rate 4.5% 5% 5.5%
Market Value £2,111,111 £1,900,000 £1,727,273
LTV 71.05% 78.95% 86.84%
Debt Yield
Net Operating Income £95,000 £95,000 £95,000
Loan Amount £1,500,000 £1,500,000 £1,500,000
Debt Yield 6.33% 6.33% 633%

 

Debt Yield vs Debt Service Coverage Ratio

Debt service coverage ratio is more closely aligned to debt yield. It aims to assess whether the borrower can cover loan payments with their expected income.

A debt service coverage ratio greater than 1 indicates that the building operating income does indeed provide enough money to pay off the debt providing all variables remain completely stable, but the higher the better. DSCRs north of 1.25 or 1.15 minimum are usually required.

The issue with DSCR is that it varies based on the amortisation period. A loan with a positive DSCR may plunge below 1 if the loan is being paid off over a shorter period. But then, the longer the amortisation period, the greater the long-term risk of the loan.

Debt Yield vs Debt Service Table

The below table shows how DCSR varies with the amortisation period. Debt yield, contrastingly, would remain a static measure across this sample.
 

DCSR
Lending Amortisation Period 15 years 20 years 25 years
Net Operating Income £90,000 £90,000 £90,000
Debt Service £94,895 £79,195 £70,151
DSCR 0.95 1.14 1.28
DEBT YIELD
Net Operating Income £90,000 £90,000 £90,000
Loan Amount £1,000,000 £1,000,000 £1,000,000
Debt Yield 9% 9% 9%

 

What is a Good Debt Yield?

Determining a good debt yield depends on the sector or industry and its expected forthcoming growth or any challenges that it may face.

Any debt yield below 10% can become very risky very quickly. Low debt yields combined with high LTVs can become unsustainable for lenders.

IPE Real Assets calculated debt yields using data from the MSCI index and found that 6% was not an uncommon figure. They concur that the general trend is for lower debt yield risk tolerance today, but also that risk is generally lower.

In short, it’s impossible to say what a good debt yield ratio is without a proper assessment of other property metrics as contextualised with the area or region’s property index and valuations through time.
 

Summary

Debt yield is useful for both lenders and investors. It should work in relative harmony with LTV and DSCR.

The main strengths of debt yield are that it operates independently of amortisation, property market value or interest rates. It’s, therefore, less sensitive when evaluating the risk of commercial properties with unstable or volatile market value.

No single real estate, investment or property metric should be used in isolation, and each should be used with reference to current and historical data.

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