There are many metrics in commercial real estate such as: cap rates, cash-on-cash yield, leverage ratio, etc., and when financing is involved there are three extremely important metrics that lenders rely on to asses inherent risks to manage real estate loans. These metrics are crucial in the lending world to obtain the best financing and there is one particular one that is considered by most securitized lenders the holy grail of lending – Debt Yield.
Debt Service Coverage Ratio (DSCR)
Debt service coverage ratio or debt cover ratio, or simply debt cover is one if not the most critical ratio in commercial lending underwriting. It is the relationship between net operating income (NOI) of the asset and the annual debt service, or interest payments. When calculating the debt service only principal and interest should be included. Taxes, insurance, reserves should be left out.
For instance, let say Ms. X own a 20-unit multifamily property in Central Harlem that is cash flowing $120,000 annually and the interest payments are $100,000 annually.
The reason why debt cover is very important, lenders are always relying on the property to service the debt. In other words, lenders want to lend to borrowers who has the ability to make their monthly payments. As such, lenders want some cushion with the coverage for unforeseen property downturn such as: sudden rise in operating expenses, lease break-up and tenants leaving the property, etc. The majority of lenders require a DCR of 1.20x:1 to 1.25x:1 – meaning there is 20% or 25% from 1.20 and 1.25 times the debt as cushion for any unforeseen circumstances that inhibit payments.
The loan-to-value, in short LTV, express in percentage (%) is any first mortgage balance obtained from lenders divided by the commercial real estate asset value. In today’s lending environment, maximum LTV varies across asset types and lenders – from 50% to 75%, and some particular lenders will go up to 80% on special case basis.
Here’s a quick example of LTV. Mr. X owns 15 properties in Harvard Square in Boston and 7 of them are mixed-used, which he developed 5 of them from ground up and the other 2 buildings were repurposing. As a local developer and investor with good credit profile, many years of investing in real estate “skin in the game” he puts a bid to a acquire a mixed used building for $2M. Due to his track record Lender A gives him $1.5M and he injects $500k equity, this comes to a 75% LTV. On the other hand, a life insurance company, Lender B issues him $1.2M and he needs to inject $840K in equity. Life insurance companies tend to lend between 60%-65% of the asset value with lower interest rates and strong debt yield.
Debt Yield (DY)
In today’s lending environment debt yield has become the holy grail of metrics for lenders. It is important because the higher it is the more attractive it is to a lender. Most lenders have a barometer of 10% for DY. Basically; DY is the asset’s NOI as a percentage of the total loan amount. For example, one of the properties of Mr.X previously mentioned has a $100,000 NOI that is collateralizing a $1M loan will generate a 10 percent debt yield.
Conceptually, DY is the return that a lender would receive if there is a foreclosure procedure on the property from day one, and here’s why this is important. The market where the property is located can become very volatile, additionally with swing in interest rates; credit spreads can have some effect on DSCR. Additionally, one can re-engineer DCR by lengthening the amortization schedule of the loan. If there is an economic shock and vacancy rise to 60%, leaving a borrower in a precarious situation to either dispose of the asset quickly, or foreclose, lenders want assurance that they are protected from the risks. Due to some of these reasons, debt yield has become the ratio of utmost greatest importance to conduit lenders, life insurance company lenders, and many traditional and non-bank institutional lenders.