What is a Debt Yield?
Debt yield is a risk measure for mortgage lenders and measures how much a lender can recoup their funds in the case of default from its owner. The ratio evaluates the percentage return a lender can receive if the owner defaults on the loan, and the lender decide to dispose of the mortgaged property.
The ratio is popular while evaluating real estate but can be used for the valuation of a yield of any project or asset that earns income. It values both leverage and risk at the same time, and it can be used over the life of the loan while remaining consistent.
This is a standalone metric that does not use interest rates, amortization schedule of loans, LTV, or any other variables.
Debt Yield Formula
The debt yield formula is:
Example of Debt Yield
Let us analyze with the help of below debt yield example:
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Andy is running a successful Toy store and requires a loan amount based on the amount yielded by the business. Presently, the shop is earning $500,000 per year, and the requirement of a loan is $2,550,000. Thus,
Debt Yield Formula = 500,000/2,550,000 = 19.60%
The lower the yield, the greater is the perceived risk of the proposed loan. It’s for this reason; lenders demand higher debt yields from riskier properties. There is no fixed benchmark, but an ideal yield of 10% is generally accepted.
Debt Yield Calculations vs. LTV (Loan to Value)
The Debt Service Coverage Ratio and the LTV ratios are the traditional methods used in commercial real estate loan underwriting. However, they are subject to manipulation.
The LTV is the total loan amount divided by the Appraised value of a property (Estimated market value provided by professionals). This market value is an estimate and subject to volatility, especially after the 2008 Financial crisis. This may not be the most accurate measure during volatile situations. Let us observe the below comparison of MV (market value) and DY:
These can also be looked at to assess Loan proposals and their feasibility. In the above instance, the yield is 6.25% or will change as per either of the components i.e., NOI or Loan amount. The above table shows the LTV ratio changing with the change in estimated Market Value (MV).
Debt Yield Calculation vs. Debt Service Coverage Ratio (DSCR)
The DSCR is the Net Operating Income divided by the annual debt service i.e., the amount of money required over a time period for debt repayments. For instance, if the required loan amount does not achieve the expected 1.10 times DSCR, a 25-year amortization could be helpful in the same. This increases the risk of the loan through is not reflected in the DSCR or LTV. Let us consider the below tables for comparing DY and DSCR:
As the yield is not impacted by the amortization time frame, it can provide an objective measure of risk with a single metric.
- In this case, the yield is 6.25%, but if the internal policy requires a minimum of 9% yield, this loan would not be approved.
- One can see that the amortization period impacts whether the DSCR requirement can be achieved. If the policy requires a DSCR of 1.1 times, only a 25 year amortization period loan will meet the requirement.
- However, whether such a long time is feasible or not is upon the management and flexibility of the internal policies to decide.
Debt Yield calculation cannot be manipulated by changing the terms of the loan to make the proposed loan more acceptable.
Options like Underwriting and Structuring of loans is much deeper instead of a single ratio; there are other factors which this yield does not consider such as:
- Demand & Supply conditions
- Guarantor Strength
- Condition of Property
- The financial position of tenants etc.;
Thus, all the aspects, including macroeconomic factors, have to be considered while making use of this ratio.
This has become of great importance to conduit lenders securitizing fixed-income loans and also to life insurance company lenders. It eliminates subjectivity and guides lenders guide in an inflated market.
Debt Yield Ratio Video
This has been a guide to Debt Yield Ratio and its definition. Here we discuss the formula to calculate Debt Yield along with practical examples. Also, we see its differences from LTV and DSCR. You can learn more about Debt Ratios from the following articles –