What is a good debt yield?

What the number is saying

Debt yield is the lender's underwritten net operating income divided by the loan amount. A 10 percent debt yield means the property produces ten cents of income a year for every dollar advanced. Turn it upside down and it reads more plainly: the loan is ten years of income. At 9 percent it is a little over eleven years, and at 8 percent it is twelve and a half.

The question behind it is what the lender would be earning if the borrower failed and it ended up owning the building having paid exactly what it lent. Nothing about the borrower, the appraisal or the interest rate enters that sentence, which is the whole point of the test.

Why no single figure is the answer

A floor is a credit decision, and it moves with three things at once. The asset class, because a property whose income is contracted for fifteen years to a strong covenant supports more debt per dollar of income than one that re prices every night. The lender, because a life company, a bank, an agency and a securitized lender are pricing different risks with different capital. And the moment, because floors rise when credit tightens and drift down when it loosens.

That is also why this page will not publish a table of current floors. We do not sample term sheets, so any number presented as the market rate would be a guess wearing the clothes of data, and it would be stale within a quarter. What can be said honestly is what the conventional levels are used for and how to read your own.

• Clearing the floor is binary, but the room above it is what matters. A loan at 9.5 percent against a 9 percent floor has almost nothing between it and a resize if the underwritten NOI comes back lower
• The lender's NOI is not the marketed NOI. A vacancy factor applied, a management fee imputed and reserves deducted can move the ratio by a point on the same building
• A debt yield computed on a stabilized or pro forma NOI is not the test. Lenders run it on what the property produces today, which is exactly why it bites hardest on value add deals

Read it against the other two tests

Debt yield is one of three tests run in parallel, alongside a maximum loan to value and a minimum debt service coverage ratio, and the lender funds the smallest of the three answers. So a comfortable debt yield tells you nothing on its own about your proceeds: it may not be the test that binds.

The interesting pattern is when it becomes the binding one. Both other tests soften when money is cheap: a lower coupon lifts the coverage ratio, and a strong bid lifts the appraisal that loan to value is measured against. Debt yield does neither, because no rate and no appraisal appear in it. It is therefore the test that tends to bind exactly in the markets where the other two have stopped being informative, which is what it was reintroduced to do.

The identity that decides your leverage

Debt yield equals the going in cap rate divided by the loan to value, exactly. It follows from the definitions: NOI over loan is NOI over value divided by loan over value.

Read backwards, that identity sets a ceiling on leverage that no loan structure can move. At a 9 percent floor, a property bought at a 6.0 percent cap rate cannot be levered past about 67 percent, and one bought at a 4.5 percent cap cannot pass 50 percent, whatever the coverage ratio looks like and however high the appraisal comes in. A longer amortization does not help. An interest only period does not help. Only more income or a lower price does.

This is the mechanism behind the observation that expensive, low yielding assets are hard to finance when credit tightens. It is arithmetic rather than sentiment, and it is worth running before a bid rather than after a term sheet.

How to improve one

Because the ratio contains only income and loan amount, there are exactly two levers and neither is a negotiation about terms. Raise the income the lender will underwrite, which means occupancy, contractual rent and expenses that survive a third party review rather than a projection. Or take less debt, which means more equity, a lower price, or a structure that funds part of the proceeds later once the income is there.

That last one is common on value add deals and worth understanding before it is offered: an earn out or a holdback sizes the initial funding on today's income and releases the rest when the property hits an agreed debt yield. It solves the test honestly rather than assuming past it, and it moves the risk of the business plan onto the borrower, which is where the lender intends it to sit.