Debt Yield is a relatively new metric and is still not used by most commercial banks who are portfolio lenders. It is used primarily by investment banks and conduit lenders to calculate their cash-on-cash return on their investment if they were to foreclose on the asset they are lending on. It is calculated by dividing the property’s NOI by the 1st Trust Deed loan amount and multiplying that by 100. For instance, suppose your commercial property has a NOI of $500,000 annually and you received a $5,000,000. The Debt Yield Ratio would be calculated as follows:
Debt Yield Ratio: ($500,000/$5,000,000) x 100 = 10%
So, the lender would receive a 10% cash-on-cash return on their investment if they were to foreclose on your property. Why is this important to certain lenders? This ratio allows lenders to quickly analyze the loan amount in reference to property’s NOI to determine the maximum loan amount that they are willing to offer. This metric was adopted because many lenders were getting into trouble by only using a debt service coverage ratio to determine maximum loan amounts. This ratio will not take into account cap rates, amortization on the loan, or even interest rate. It is only used to compare NOI to the 1st Trust Deed loan amount.
Most lenders will require a Debt Yield above 10% on all of their loans. Some conduit lenders may consider a property with a slightly lower yield because it is has a superior location or is a superior product, but 10% is a good rule of thumb because this generates a loan-to-value ratio of approximately 65% – 70%, target leverage for conduit lenders. Although this is currently used mostly by conduit lenders, don’t be surprised if commercial banks soon adopt the Debt Yield Ratio to determine acceptable maximum loan amounts.
To summarize, if you are considering financing to purchase a new property or refinance one of your existing properties, take a moment to calculate the Debt Yield Ratio on your property that would be acceptable to a lender. This will allow you to go into a meeting with your prospective lender with a good idea of what they may offer you in terms of a loan amount. If you are looking for mezzanine financing on top of your 1st Trust Deed loan it is important to know that the mezzanine loan will not have any effect on your Debt Yield Ratio.