Debt Yield vs DSCR: The Lender Test Most Borrowers Never Run
Debt yield is a property's net operating income divided by the loan amount, so a building earning $500,000 a year against a $5 million loan has a 10 percent debt yield, and lenders use it to cap loan size. Unlike the debt service coverage ratio, it ignores the interest rate, the amortization and any interest-only period. A deal that clears every DSCR test you run can still come back from underwriting with a smaller loan than you planned, and debt yield is usually the reason.
DSCR divides NOI by the annual loan payment, which means you can improve it without improving the building. A lower rate, a 35-year amortization or two years of interest-only payments will each push the ratio up while the property earns exactly what it did before, and lenders know it. Debt yield answers the question they care about at maturity or in foreclosure: if they took the building back, what would it earn on the money they lent?
Take $500,000 of NOI and a $5.5 million loan amortized over 30 years, and run it at two interest rates. At 6 percent, annual payments come to about $395,700 and DSCR lands near 1.26, just over a typical 1.25 minimum. At 7.5 percent, payments climb to about $461,500 and DSCR falls to roughly 1.08. Debt yield stays at 9.1 percent at both rates, and a lender with a 10 percent floor will cut the loan to $5 million no matter which rate you are quoted.
Switch that same $5.5 million loan to interest-only at 6 percent and the annual payment drops to $330,000, pushing DSCR to about 1.52, a ratio that looks comfortable on any term sheet. Debt yield is still 9.1 percent, and an underwriter worried about refinancing risk at maturity will size the loan to that number.
Lenders size every loan to the most restrictive of three tests: loan to value, DSCR and debt yield, and many also calculate DSCR at a stress rate above your note rate. In a high-rate market, stressed DSCR and debt yield frequently bind before LTV does, and borrowers who modeled only LTV learn this when the term sheet arrives with less money on it.
Debt yield also equals the cap rate divided by the loan to value, which gives you a ten-second check on any offering memorandum. A 5 percent cap rate at 75 percent leverage works out to about 6.7 percent, below what most lenders accept. An 8 percent cap rate at the same leverage gives about 10.7 percent. In California, where apartment buildings often trade at lower cap rates than most of the country, buyers can sit comfortably inside a 75 percent LTV and still fail a 9 or 10 percent debt yield.
The NOI the lender divides is its own number, because underwriters apply market vacancy, a market management fee and their own expense comparables before running the test. Their NOI usually comes in below the seller's, sometimes by enough to cut hundreds of thousands of dollars from the loan.
Before you make an offer, divide your own underwritten NOI by the loan you need and compare the result to the lender's minimum. Ask each lender you talk to what debt yield floor and stress rate it uses for your property type. If debt yield is the test that binds, the fix is more equity or more income, and both are far easier to arrange before the term sheet than after it.
Finding out which test limits your loan before the term sheet arrives gives you time to adjust the price, the equity or the loan program while you still have choices. I help sponsors model their deals against every sizing test a lender will run and review term sheets once the quotes come in. If you have a deal in front of you, send it to amer@awadcapitaladvisors.com, and I can help you see how much loan the property will actually support.