CRE-Finance LLC Explains How the Debt Yield Works in a Commercial Mortgage
Online, April 26, 2014 (Newswire.com) - When it comes to a commercial mortgage loan, the most important issue to most borrowers is not, "What is the interest rate?" Most banks and conduits offer interest rates that are within 0.25% of each other. Instead, commercial mortgage borrowers are most concerned about, "How large of a commercial loan can I get?" The mortgage professionals at CRE-Lending LLC would like to share the following explanation with you.
In the past, the size of your new commercial loan was limited by either the Loan-To-Value Ratio (LTV) or the Debt Service Coverage Ratio (DSCR). For example, the lender might say, "We will lend up to 75% loan-to-value, but the loan must also satisfy a 1.25 debt service coverage ratio."
In the past, it was the debt service coverage ratio that was the true limiting ratio. For example, a lender might say, "I see that you are buying this commercial property for $10 million. In terms of loan-to-value ratio, you could qualify for a loan of $7.5 million. However, in order to satisfy the 1.25 debt service coverage requirement, the largest loan we can make you is $7.1 million (71% LTV)."
Unfortunately, there is now a third sheriff in town, and this new ratio is limiting commercial loan sizes even more. This new underwriting ratio in commercial real estate finance is called the Debt Yield Ratio, and this ratio is limiting large commercial loans to just 58% to 63% loan-to-value.
The Debt Yield Ratio is defined as the Net Operating Income (NOI) divided by the first mortgage debt (loan) amount, times 100%. For example, let's say that a commercial property has a NOI of $437,000 per year, and some conduit lender has been asked to make a new first mortgage loan in the amount of $6,000,000. Four-hundred thirty-seven thousand dollars divided by $6,000,000 is .073. Multiplied by 100% produces a Debt Yield Ratio of 7.3%. What this means is that the conduit lender would enjoy a 7.3% cash-on-cash return on its money if it foreclosed on the commercial property on Day One.
Please notice that this new Debt Yield Ratio does not even look at the cap rate used to value the property. It does not consider the interest rate on the commercial lender's loan, nor does it factor in the amortization of the lender's loan; e.g., 20 years versus 25 years. The only factor that the Debt Yield Ratio considers is how large of a loan the commercial lender is advancing compared to the property's NOI. This is intentional. Commercial lenders and CMBS investors want to make sure that low interest rates, low caps rates, and high leverage never again push real estate valuations to sky-high levels, states Todd Tretsky of CRE-Finance LLC.
So what is an acceptable Debt Yield Ratio? Ten percent - this is the lowest number that most conduit lenders are using to determine the maximum size of their advances. In our example above, the subject commercial property generated a NOI of $437,000. Four-hundred thirty-seven dollars divided by 0.10 (10% expressed as a decimal) would suggest a maximum loan amount of $4,370,000.
It is the money center banks and investment banks originating fixed-rate, conduit-style commercial loans that are using the new Debt Yield Ratio. Commercial banks, lending for their own portfolio, and most other commercial lenders have not yet adopted the Debt Yield Ratio.
You will notice in my definition of the Debt Yield Ratio that I used as the "debt" only the amount of the first mortgage debt. The reason why I threw in the word "first mortgage" is because more and more new conduit deals involve a mezzanine loan at the time of origination. The existence of a sizable mezzanine loan behind the first mortgage does NOT affect the size of the conduit's new first mortgage, at least as far as this ratio is concerned.
Will conduits ever accept a Debt Yield ratio of less than 10.0%? Yes, if the property is very attractive, and it is located in a primary market, like Washington, DC; New York; Boston; or Los Angeles - an area where cap rates are exceedingly low (4.5% to 5%) - a conduit lender might consider a Debt Yield as low as 8.0%.
Debt yields are also coming down. The CMBS market is ravenous for commercial mortgage loans, so debt yield ratios of 9% are becoming commonplace. I predict that within 18 months the minimum-acceptable Debt Yield Ratio will finally stabilize at around 8.0%.
Why did the conduit industry start to use the Debt Yield Ratio? For over 50 years commercial real estate lenders determined the maximum size of their commercial mortgage loans using the Debt Service Coverage Ratio (DSCR). For example, a commercial lender might insist that the Net Operating Income (NOI) of the property be at least 125% of the proposed annual debt service (loan payments).
But then, in the mid-2000's, a problem started to develop. Bonds investors were ravenous for commercial mortgage-backed securities, driving yields waaaaay down. As a result, commercial property owners could regularly obtain long-term, fixed rate conduit loans in the range of 6% to 6.75%.
At the same time, dozens of conduits were locked in a bitter battle to win more conduit loan business. Each promised to advance more dollars than the other. Loan-to-value ratio's crept up from 70% to 75% and then to 80% ... and then up to 82%! Commercial property investors could achieve a historically huge amount of leverage, while locking in a long-term, fixed-rate loan at a very attractive rate.
Not surprisingly, the demand for standard commercial real estate (the four basic food groups - multifamily, office, retail and industrial) soared. Cap rates plummeted, and prices bubbled-up to sky-high levels.
When the bubble popped, conduit lenders found that many of their loans were significantly upside down. The borrowers owed far more than the properties were worth. The lenders swore to never let this happen again. The CMBS industry therefore adopted a new financial ratio - the Debt Yield Ratio - to determine the maximum size of their commercial real estate loans.
If you have any questions regarding commercial real estate or are seeking financing, then contact Todd Tretsky at 212-851-6926 or Rich at 212-257-7307 or visit us at www.cre-finance.com.