Debt yield translated into the LTV and DSCR it implies, so that a lender's three tests sit on one scale.
A good debt yield is one that is consistent with the lender's other two limits at today's cap rate and interest rate: at least the cap rate divided by the maximum LTV, and at least the minimum DSCR times the loan constant. On an illustrative property with $4.8 million of NOI at a 6.00 per cent cap rate, a 65 per cent LTV and a 1.25x DSCR at 6.50 per cent, those give 9.23 and 9.48 per cent, so a good debt yield here is 9.48 per cent or more. A fixed rule such as "10 per cent" means 50 per cent LTV in one market and 80 per cent in another.
Worked in full in Real Estate Fund Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Debt yield is NOI divided by the loan amount. Lenders like it because it ignores both the cap rate and the interest rate, the two inputs a borrower can argue about. That is also why there is no single good level: the same debt yield implies a different leverage and a different coverage every time the market moves.
| Input | Value |
|---|---|
| Net operating income | $4,800,000 |
| Cap rate | 6.00% |
| Value (NOI / cap rate) | $80,000,000 |
| Maximum LTV | 65% |
| Minimum DSCR | 1.25x |
| Interest rate, 30-year amortisation | 6.50% |
| Loan constant (annual debt service / loan) | 7.585% |
| Loan requested | $52,000,000 |
Step 1. Debt yield on the requested loan
$4,800,000 / $52,000,000 = 9.23 per cent. The loan is 65.0 per cent of value, exactly at the LTV limit.
Step 2. The debt yield the LTV limit implies
Debt yield = NOI / loan = (value × cap rate) / (value × LTV) = cap rate / LTV. At 6.00 / 0.65 the LTV limit is the same thing as a 9.23 per cent debt yield.
Step 3. The debt yield the DSCR limit implies
DSCR = NOI / (loan × constant) = debt yield / constant, so the minimum is 1.25 × 7.585% = 9.48 per cent. In Excel the constant is =-PMT(6.5%/12, 360, 1)*12.
Step 4. Take the higher
9.48 per cent binds. The requested $52,000,000 at 9.23 per cent passes the LTV test but covers debt service of $3,944,104 only 1.22 times. The maximum loan on the DSCR test is $50,627,462.
The two identities are the useful part. Debt yield is the LTV seen through a cap rate, and the DSCR seen through a loan constant. Once a lender's LTV and DSCR limits are written as debt yields, the three tests can be compared on one scale and the binding one read off directly. The full proceeds calculation across all the tests is in how to calculate the maximum loan on a commercial property.
| Cap rate | 8.00% DY | 9.00% DY | 10.00% DY | 11.00% DY |
|---|---|---|---|---|
| 5.00% | 62.5% | 55.6% | 50.0% | 45.5% |
| 6.00% | 75.0% | 66.7% | 60.0% | 54.5% |
| 7.00% | 87.5% | 77.8% | 70.0% | 63.6% |
| 8.00% | 100.0% | 88.9% | 80.0% | 72.7% |
A 10 per cent debt yield is a conservative 50.0 per cent LTV on a property valued at a 5.00 per cent cap rate and an aggressive 80.0 per cent on one at 8.00. That is the intended effect, from the lender's side: in a low-yield market the debt yield caps leverage before the valuation can inflate it. It is also why a borrower in a low cap rate market finds the debt yield test binding long before the LTV.
| Interest rate | Loan constant | DY needed for 1.25x | DSCR at 10% DY | Max loan at 1.25x, $ |
|---|---|---|---|---|
| 4.50% | 6.08% | 7.60% | 1.64x | 63,155,571 |
| 5.50% | 6.81% | 8.52% | 1.47x | 56,358,964 |
| 6.50% | 7.58% | 9.48% | 1.32x | 50,627,462 |
| 7.50% | 8.39% | 10.49% | 1.19x | 45,765,641 |
At 7.50 per cent, even a 10 per cent debt yield fails a 1.25x DSCR. The debt yield that counts as good rises by roughly one point for each point on the rate, because the loan constant does. A lender that kept the same debt yield floor through a rate cycle would have been loose at the top of it.
Debt yield is also a cushion. At 10 per cent and a 7.585 per cent constant, NOI can fall 24.2 per cent before DSCR reaches 1.00x. At the requested 9.23 per cent, the cushion is 17.8 per cent.
Treating one number as good everywhere. Borrowers quote "lenders want 10 per cent" and lenders sometimes set a single floor across asset types and cycles. On the property above, 10 per cent would limit the loan to $48,000,000, $2.6 million below what the DSCR allows, while in an 8.00 per cent cap rate market the same floor would let the loan run to 80.0 per cent of value. Convert every debt yield into the LTV and the DSCR it implies before calling it good or bad; the same check for the cover ratio itself is in what is a good DSCR for commercial real estate. How the three covenants then behave as NOI falls is worked in which covenant breaches first.
A good debt yield is the higher of cap rate / maximum LTV and minimum DSCR × loan constant: 9.48 per cent on these terms, where DSCR binds. Below it, the loan fails a test the lender already has; well above it, the borrower is leaving proceeds on the table. The free workbook for this case sizes proceeds under four tests at once, names the binding one and shows the headroom to the next.
Divide the cap rate by the debt yield. Debt yield is NOI over the loan and value is NOI over the cap rate, so LTV = cap rate / debt yield. A 10 per cent debt yield is 60.0 per cent LTV on a property valued at a 6.00 per cent cap rate, 50.0 per cent at 5.00 and 80.0 per cent at 8.00.
Divide the debt yield by the loan constant, annual debt service over loan amount. At 6.50 per cent over 30 years the constant is 7.585 per cent, so a 10 per cent debt yield gives a DSCR of 1.32x, and a 1.25x minimum requires a debt yield of 9.48 per cent. At 7.50 per cent interest the requirement rises to 10.49.
It depends on the cap rate and the rate. At a 5.00 per cent cap rate it limits leverage to 50.0 per cent LTV, which is conservative; at 8.00 per cent it allows 80.0. At 6.50 per cent interest it gives 1.32x DSCR and lets NOI fall 24.2 per cent before coverage reaches 1.00x.
This article is one calculation from Real Estate Fund Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.