Debt yield explained

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Was at a conference on syndication yesterday and came across an interesting idea: debt yield.

Debt yield is yet another test lenders use to determine whether or not they should make a loan on a 5+ unit deal.

The math looks like this: Divide the building’s NOI by the proposed loan amount. The resulting quotient is the “debt yield”.

For example:

  • Say we’re buying a $1MM building
  • Because it’s one of my deals, the NOI is $70k (if it were someone else’s, we could use $50k)
  • We want to use a sensible purchase loan at 65% LTV, or $650k
  • Bank calculates a debt yield of $70k / $650k = 10.8%

Attentive readers will recognize that this equation looks a lot like a cap rate, which compares the NOI to the price of the building. Except, because the equity isn’t taken into account, the debt yield on a given deal will invariably be higher than the cap rate (unless you’re asking for a 100% LTV purchase loan… in which case I’d like an introduction to your bank, please.).

The similarity to cap rate is intentional. What the bank is using the debt yield to understand is this: Assuming the borrow misses the fist debt payment and the bank needs to foreclose (wiping out the equity and trading its unpaid loan balance for ownership of the property), what kind of yield can the bank expect on its money?

Two problems occur to me in thinking about debt yield, one small and one big:

1. The small problem is that the equation does not take into account the time and expense involved in foreclosing. There’s probably a rule of thumb out there (varying by state, since foreclosures are different in each state), but I don’t know what it is, since I’ve never foreclosed on anyone before.

2. The larger problem is with the NOI part of the equation. In the event someone borrows and then misses an early debt payment, you have to assume something is royally messed-up at the property. In that scenario, it seems extraordinarily unlikely that the NOI upon completion of the foreclosure is going to look anything like the pro forma NOI against which the bank loaned. In real life, the NOI is 99.9% certain to be materially less than pro forma (since, if it was close, the lender wouldn’t have defaulted).

Based on the above, I’m pretty convinced debt yield tells you nothing that the DSCR and LTV tests don’t already tell you. But bankers have to have some analysis tools to use to talk themselves into and out of doing deals, so they might as well use this one…

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