Debt Yield: a Worked Example

The two ratios that usually size a property loan each lean on a market price. Interest cover divides income by interest, so it improves when rates fall. Loan to value divides the loan by a valuation, and a valuation is the income divided by a capitalisation rate that also tends to fall when money is cheap. In a low-rate market both ratios can pass a larger loan against a building whose rent has not changed at all.

Debt yield takes both prices out. A handbook for US bank examiners, published by one of the federal supervisors, describes it as a measure of risk independent of the interest rate, the amortisation period and the capitalisation rate. Read the other way, it is roughly the income return the lender would earn on its money if it had to take the building over at the loan amount, before the costs of doing so.

Net operating income is before interest, depreciation and tax. The judgment is in what goes into it: rent being paid now or rent the borrower expects, an allowance for vacancy, and whether a sum is set aside for the roof and the lifts. A lender working on in-place income and a borrower working on next year's rent can produce two different yields from the same building.

The last line shows how the ratio connects to the other two. At a 6% cap rate and 60% loan to value, the debt yield is 10%. If the cap rate falls to 5% and the lender keeps lending 60% of value, the debt yield falls to 8.3% without anyone deciding to lend more against the income.

A medical centre let to a general practice, a pharmacy and an imaging clinic, constructed for this page like every figure in it, earns net operating income of US$1.25m. Three moments in its financing:

At the refinance, loan to value was unchanged and interest cover was better than at first lending. Neither objected to a loan US$3m larger. Only debt yield said that the same income now stood behind 25% more debt. When the cheap money ended, the other two ratios moved to where debt yield had been pointing all along. A lender that had required 9.5%, a level chosen for this example, would have capped the refinance at 1.25 ÷ 9.5% = US$13.2m.

Both start from the building's net income and both come out as a percentage, which is why they are confused. A cap rate is the market's price for the income: what buyers pay for each dollar of it, read from sales of similar buildings. Debt yield is the lender's position against the income: how much it has advanced for each dollar. The cap rate can move every quarter without the building changing; the debt yield moves only when the income or the loan does.

It also differs from interest cover, which answers whether this year's income pays this year's interest. Interest cover is the test of the borrower's ability to service the loan; debt yield is closer to a test of how much loan the income can carry at whatever rate the market sets in future.

DEFINED IN ONE PARAGRAPH → · LVR, SECURITY AND COLLATERAL → · DEBT SERVICE COVERAGE →

Its use differs by market. It is most established in US commercial property lending, where the examiners' handbook lists a minimum debt yield among the underwriting standards a bank's policy may set and debt yield among the common financial covenants. In UK and European commercial property loans it appears in some agreements beside loan-to-value and interest cover tests, sometimes as a level at which surplus cash is held back rather than one that causes a default. In New Zealand and Australia interest cover and loan to value usually lead, and a desk that runs debt yield uses it as a cross-check.

Where it decides a file is the refinance of a loan written when money was cheap, and the sizing of a new loan in a market where values have run ahead of rents. A borrower asking for more because the valuation rose is asking the lender to lend against the cap rate. Debt yield is the number that shows it, and it is the reason a lender can say the building is worth more and still decline to lend more against it.

WEIGHTED AVERAGE LEASE EXPIRY → · RENT ROLL →