# What is debt yield, formula, and why is it so important in real estate?

The debt yield calculation is a risk measure used in commercial lending.

It may be lesser known than the loan-to-value or debt service coverage ratios, but it’s arguably more valuable. The ratio’s power lies in its consistency—allowing it to be used objectively when comparing properties.

After reading this article, you’ll have a clear understanding of this simple but potent risk assessment tool.

## What is debt yield?

The debt yield formula is a calculation that helps lenders assess how quickly losses can be recouped if a borrower defaults. It offers lenders a method to manage their leverage.

All else equal, the lower the debt yield percentage, the riskier the loan. While exceptions exist, most lenders will not offer loans with a debt yield ratio lower than 0.1 (10%).

## How to calculate debt yield

You can calculate debt yield by dividing the net operating income by the total loan value.

The net operating income (NOI) represents the property’s profitability. It is the amount left over after all operating expenses are deducted from the revenue earned by the property.

Let’s look at a simple debt yield calculation example. Assume a property with an NOI of $100,000 requires a loan for $1 million. What’s the debt yield?

*Debt yield formula = NOI ÷ Loan Value*

*Debt yield formula = $100,000 ÷ $1,000,000*

*Debt yield formula = 0.1 or 10%*

Now assume that the same property enjoys an NOI of $200,000.

*Debt yield formula = NOI ÷ Loan Value*

*Debt yield formula = $200,000 ÷ $1,000,000*

*Debt yield formula = 0.2 or 20%*

Assuming no other differences, a lender would prefer to provide a loan in the second example because the debt yield is twice as high. This means the lender would recoup the loan amount twice as fast.

## Why is the debt yield metric so important in real estate?

The debt yield formula is a widely accepted because it provides an apples-to-apples comparison when assessing the risk profile of various properties.

It is not prone to changing interest rates, turbulent property values, misleading cap rates, or other fluctuating factors.

Chances are you heard of it before the debt yield calculation. The LTV ratio compares the amount of debt used to purchase a property versus the property’s value.

But while it can be a valuable risk metric, it’s susceptible to swings in cap rates.

A cap rate is the estimated potential return an investor expects on a property. The inputs used to calculate cap rates can vary widely, making comparisons challenging, if not useless.

Another popular ratio is the debt-service coverage ratio (DSCR).

It attempts to measure the ability of a property’s NOI to cover debt obligations. Lenders usually look for DSCRs of 1.25 or more, meaning the NOI is 1.25 times more than the debt service.

The problem with the DSCR? Fluctuating interest rates can heavily influence it. In a volatile rate environment, the DSCR becomes increasingly less valuable.

While other ratios can be helpful, many, like the LTV and debt-service ratios, are prone to subjectivity.

The debt yield calculation, on the other hand, is not. It doesn’t require cap rate inputs, nor do interest rate swings influence it.

## How do you interpret a debt yield calculation?

As discussed, the debt yield formula produces a ratio or percentage, but how does that figure tell how quickly a loan can be recouped?

Fortunately, by dividing 100% by the debt yield, you can obtain an estimated recoup time. Using the same examples, the recoup time can be calculated as follows:

*Recoup Time = 100% ÷ Debt Yield*

*Recoup Time = 100% ÷ 10%*

*OR*

*Recoup Time = 1 ÷ 0.1*

*Recoup Time = 10 years*

Now, let’s use the higher debt yield ratio of 0.2 to determine the recoup time:

*Recoup Time = 100% ÷ Debt Yield*

*Recoup Time = 100% ÷ 20%*

*OR*

*Recoup Time = 1 ÷ 0.2*

*Recoup Time = 5 years*

Again, this tells us a higher debt yield equates to a shorter payback period. For a lender, this means they can recoup the loan faster should the borrower be unable to pay.

In other words, it’s less risky.

## Maximum loan amount

You can also calculate the maximum loan amount using a minimum debt yield.

Assume a lender stipulates it only provides loans on properties with debt yields of 10% or higher (10% minimum). What is the maximum loan amount a borrower could obtain, assuming their property has an NOI of $150,000?

*Maximum Loan Amount = NOI / Debt Yield*

*Maximum Loan Amount = $150,000 / 10%*

*Maximum Loan Amount = $1,500,000*

Therefore, the lender could obtain a loan valued at $1.5 million, assuming an NOI of $150,000.

While numerous alternative ratios exist in commercial lending, the debt yield formula remains one of the most popular. Its simplicity and consistency can’t be overstated.

This straightforward calculation offers a quick and easy opportunity to gauge the risk of a loan without being susceptible to the many fluctuating variables.

Put another way, the debt yield ratio ensures a loan amount won’t be inflated due to low interest rates, lengthy amortization periods, or low market cap rates.

For this reason, it continues to play a vital role in commercial lending.