What is Debt Yield?
The Debt Yield measures the riskiness of a real estate loan by estimating the return earned by the lender to recoup the original investment in the event of property foreclosure (i.e. default).
How to Calculate Debt Yield
The debt yield is frequently utilized by lenders in the commercial real estate market (CRE) as a method to measure credit risk in underwriting.
In short, the debt yield is the ratio between a property’s net operating income (NOI) and total loan amount, expressed as a percentage.
- Net Operating Income (NOI) → Net operating income, or “NOI” for short, is a fundamental real estate metric used to measure a property’s cash flows and profitability. The NOI of a rental property is calculated by first determining the property’s total income – the sum of its rental and ancillary income – and then subtracting its operating expenses.
- Loan Amount → The total loan amount refers to the outstanding principal balance associated with real estate financing, such as a mortgage loan.
Conceptually, the debt yield is the estimated return a real estate lender receives relative to the original loan amount provided to the borrower under the hypothetical scenario of default (and foreclosure).
Because non-operating costs such as financing costs and income taxes are not part of the net operating income (NOI) calculation, the metric is considered an unlevered, pre-tax measure of profitability (i.e. “capital structure neutral”). The debt yield is therefore suited for comparability purposes.
The items excluded from the NOI calculation, such as capital reserves, capital expenditures, and tenant improvements, are unrelated to the property’s core operations.
Likewise, the debt service component is also excluded since it falls under the category of financing costs.
The calculation of the debt yield metric is a three-step process:
- Calculate Net Operating Income (NOI)
- Divide Net Operating Income (NOI) by the Loan Amount
- Convert Debt Yield from Decimal to Percentage Form (Multiply by 100)
Debt Yield Formula
The formula to calculate the debt yield divides the net operating income (NOI) by the total loan amount.
Where:
- Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses
Ancillary income refers to the non-rental sources of income, such as reimbursements on utilities and fees charged to tenants for amenities access.
On the other hand, direct operating expenses are the costs tied to the operations of the property, such as repair and maintenance costs, marketing, general and administrative expenses, and utilities.
The debt yield formula can also be expressed as the property’s annual NOI divided by the difference between the purchase price and the down payment.
Note: While income taxes are excluded in the net operating income (NOI) metric, the property taxes paid by the owner must be included.
