Debt Yield Calculator

Why lenders added a third test

For most of the history of commercial lending, two tests decided how much a property could borrow. Loan-to-value capped the advance against what the asset was worth; debt service coverage capped it against what the income could pay. Both are still run on every deal. Debt yield was added because each of them can be made to look better than the risk underneath it.

Loan-to-value rests on an appraisal, and appraisals follow the market. When cap rates compress, the same income supports a higher value, and the same percentage advance becomes a larger loan against income that has not changed. Coverage rests on the rate and the schedule. A low rate, a long amortization or an interest-only period lowers the payment, and the same loan on the same income shows a higher ratio. In both cases the loan grows without the property earning a dollar more.

Debt yield takes both levers away. It is the income divided by the loan, with nothing else in the calculation, so it moves only when one of those two moves. That makes it the lender’s measure of a worst case: if the borrower walks away and the lender takes the building, the debt yield is roughly the return the income pays on the money the lender has out. A 10% floor says the lender wants to earn ten cents a year on every dollar it advanced, from the property alone, whatever happens to rates or values.

Where it binds

Debt yield is the constraint that cuts proceeds when money is cheap and values are high — exactly the conditions in which the other two tests are easiest to pass. On a 7.00% cap rate asset financed at 70% loan-to-value it lands at 10.00%, right on the common floor. On a 5% cap rate asset the same leverage produces a debt yield of about 7%, and the lender will cut the loan until it reaches its floor no matter how comfortable the coverage looks at the quoted rate.

One income, three ratios: debt yield, cap rate and coverage

Debt yield sits between two ratios borrowers already use, and the conversions between them are worth knowing by heart, because they let you read a deal before you have sized anything.

• Debt yield equals cap rate divided by loan-to-value. A 7.00% cap rate at 70% leverage is a 10.00% debt yield. A 6% cap rate at the same leverage is about 8.6%, already below a 10% floor before any other test is run.
• Coverage equals debt yield divided by the loan constant. At 6.75% over thirty years the constant is 7.78%, so a 10.00% debt yield is 1.28x coverage. The debt yield is fixed by the deal; the coverage moves with every rate quote.
• A debt yield sets a rate ceiling for each schedule. To clear 1.25x, the loan constant can be no more than the debt yield divided by 1.25 — 8.00% here. How high a rate that allows depends on the amortization.

The amortization effect is larger than most borrowers expect. At a 10.00% debt yield, coverage of 1.25x holds up to about 7.02% on a thirty-year schedule, 6.36% on twenty-five, 5.12% on twenty and only 2.50% on fifteen. Shortening the amortization repays principal faster, which raises the constant and leaves less room for interest. That is why a lender who will not move on rate will sometimes move on the schedule instead, and why the amortization control above changes only the rate read.

Using it in practice

Run debt yield first. If the income cannot reach the lender’s floor on the loan you need, no rate and no appraisal will fix it, and the conversation has to be about a smaller loan or a higher NOI. If it clears comfortably, the deal is usually decided by coverage at the quoted rate, and the DSCR solver is the next place to look. To run all three tests together on a purchase, use the commercial real estate investment calculator.