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What Is Debt Yield?
Debt yield is a risk measure for mortgage lenders and measures how much a lender can recoup its funds in the case of default from its owner. The ratio evaluates the percentage return a lender can receive if the owner defaults.
This ratio is calculated when the lender decides to dispose of the mortgage property used as collateral, in case the borrower defaults. It is popular while evaluating real estate but can be used to evaluate a yield of any project or asset that earns income. It values both leverage and risk simultaneously, and it can be used over the life of the loan while remaining consistent.
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- Debt yield is a tool for estimating risks for mortgage lenders. It also determines how much a lender may recover funds in the case of default from the owner.
- It evaluates the percentage return a lender may get when the owner defaults on the loan and the lender makes over the mortgaged property.
- It is popularly used in determining real estate but can be used to can also be used to examine the project or asset yield that gains income.
- Its computation cannot be misled by altering the loan terms to make the proposed loan more acceptable.
Debt Yield Explained
Debt yield ratio refers to the method of measuring how much loan recovery the lender can make by selling the property or collateral used against the loan. This is done only if the borrower is unable to pay back the pending loan amount due to some unforeseen situations of bankruptcy. This measurement is used to calculate the loan risk even before lending so as to ensure that the process is done as per the market rates and is a worthwhile investment opportunity.
Debt Yield calculation cannot be manipulated by changing the loan terms 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 that 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 using this ratio.
This has become important to conduit lenders securitizing fixed-income loans and life insurance company lenders. Debt yield calculation eliminates subjectivity and guides lenders in an inflated market.
It is a standalone metric that does not use interest rates, amortization schedule of loans, LTV, or other variables.
Debt Yield Ratio Explained in Video
Formula
Let us now look at the debt yield calculation in detail.
The debt yield formula is:
Debt Yield = Net Operating Income / Value of the Property
As per the above formula, the debt yield is directly proportional to net operating income and inversely proportional to loan value. Thus, a higher loan value may reduce the yield if income does not rise proportionately. In case of real estate debt yield or otherwise, a high yield indicates low risk due to income being more than loan value. but low yield indicates high risk since income is lower than loan value.
Example
Let us analyze with the help of the below debt yield ratio example:
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 for 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. For this reason, lenders demand higher debt yields from riskier properties. There is no fixed benchmark in case of debt yield test and an excellent yield of 10% is generally accepted.
Use In Real Estate
This metric is very useful for real estate lenders because it can be used to determine the level of risk in case of default. The risk factor in this case is based on how easily or quickly the lender can recover the loss. Thus, real estate debt yield protects them from making over risky investment decisions and evaluate the viability of an investment.
If real estate investors can calculate the yield, then they can anticipate in advance the level of loss or even compare the property investments and select the best option that is most profitable and productive.
Debt Yield 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. It may not be the most accurate measure during volatile situations. Let us observe the below comparison of MV (market value) and DY:
| Loan Amount | $1,600,000 | $1,600,000 | $1,600,000 |
| Net Operating Income (NOI) | $1,000,000 | $1,000,000 | $1,000,000 |
| Cap Rate | 4.50% | 5.00% | 5.50% |
| Market Value (MV) | $2,211,111 | $1,950,000 | $1,827,275 |
| LTV (Loan Amt. / MV) | 72.36% | 82.05% | 87.56% |
| Net Operating Income | $1,00,000 | $1,00,000 | $1,00,000 |
| Loan | $1,600,000 | $1,600,000 | $1,600,000 |
| Debt Yield (NOI/Loan) | 6.25% | 6.25% | 6.25% |
These can also be looked at to assess Loan proposals and their feasibility. The above table shows the LTV ratio changing with the estimated Market Value (MV) change. In the above instance, the yield is 6.25% or will change as per the components, i.e., NOI or Loan amount.
Debt Yield 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 some time 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. It increases the loan risk that is not reflected in the DSCR or LTV. Let us consider the below tables for comparing DY and DSCR:
| 15 Years | 20 Years | 25 Years | |
| Net Operating Income | $1,00,000 | $1,00,000 | $1,00,000 |
| Debt Service | $107,650 | $96,150 | $89,975 |
| DSCR (NOI/Debt Service) | 0.92 | 1.04 | 1.11 |
| 15 Years | 20 Years | 25 Years | |
| Net Operating Income | $1,00,000 | $1,00,000 | $1,00,000 |
| Loan | $1,600,000 | $1,600,000 | $1,600,000 |
| Debit Yield (NOI/Loan) | 6.25% | 6.25% | 6.25% |
- In this case, the debt yield test gives a value of 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, deciding whether such a long time is feasible is upon the management and flexibility of the internal policies.
Frequently Asked Questions (FAQs)
A good debt yield ratio is subjective and can vary depending on the lender's risk tolerance, the property type, and the current market conditions. Furthermore, significant lenders opt for 10% or above debt yields, but the requirements differ over the period.
Debt yield is essential since it provides a lender an awareness of how wrong things may get represented even before the lender has yet to complete whole on its investment. Moreover, it is essential for reasons like, risk assessment, loan-to-value ratio, and investment analysis
From the lender's perspective, a high debt yield is better as it indicates a higher potential return on investment. Moreover, the lenders ask for these yields from high-risk properties since they believe that if the yield is lower, the perceived risk of the yield is lower, the perceived risk of the proposed loan will be substantial.
Recommended Articles
This has been a guide to what is Debt Yield Ratio. We explain it with formula, use in real estate, differences with DSCR & LTV along with example. Also, we see the differences between LTV and DSCR. You can learn more about Debt Ratios from the following articles –
