The debt yield is becoming an increasingly important ratio in commercial real estate lending. Traditionally, lenders have used the loan to value ratio and the debt service coverage ratio to underwrite a commercial real estate loan. Now, the debt yield is used by some lenders as an additional underwriting ratio. However, since it’s not widely used by all lenders, it’s often misunderstood. In this article, we’ll discuss the debt yield in detail, and we’ll also walk through some relevant examples.
First, what exactly is the debt yield? Debt yield is defined as a property’s net operating income divided by the total loan amount.
For example, if a property’s net operating income is $100,000 and the total loan amount is $1,000,000, then the debt yield would simply be $100,000 / $1,000,000, or 10%.
The debt yield equation can also be re-arranged to solve for the Loan Amount:
For example, if a lender’s required debt yield is 10% and a property’s net operating income is $100,000, then the total loan amount using this approach would be $1,000,000.
The debt yield provides a measure of risk that is independent of the interest rate, amortization period, and market value. Lower debt yields indicate higher leverage and therefore higher risk. Conversely, higher debt yields indicate lower leverage and therefore lower risk. The debt yield is used to ensure a loan amount isn’t inflated due to low market cap rates, low-interest rates, or high amortization periods. The debt yield is also used as a common metric to compare risk relative to other loans.
What’s a good debt yield? As always, this will depend on the property type, current economic conditions, strength of the tenants, strength of the guarantors, etc. However, according to the Comptroller’s Handbook for Commercial Real Estate, a recommended minimum acceptable debt yield is 10%.
The debt service coverage ratio and the loan to value ratio are the traditional methods used in commercial real estate loan underwriting. However, the problem with using only these two ratios is that they are subject to manipulation. The debt yield, on the other hand, is a static measure that will not vary based on changing market valuations, interest rates and amortization periods.
The loan to value ratio is the total loan amount divided by the appraised value of the property. In this formula, the total loan amount is not subject to variation, but the estimated market value is. This became apparent during the 2008 financial crises, when valuations rapidly declined and distressed properties became difficult to value. Since market value is volatile and only an estimate, the loan to value ratio does not always provide an accurate measure of risk for a lender.
As you can see, the LTV ratio changes as the estimated market value changes (based on direct capitalization). While an appraisal may indicate a single probable market value, the reality is that the probable market value falls within a range and is also volatile over time. The above range indicates a market cap rate between 4.50% and 5.50%, which produces loan to value ratios between 71% and 86%. With such potential variation, it’s hard to get a static measure of risk for this loan. The debt yield can provide us with this static measure, regardless of what the market value is. For the loan above, it’s simply $95,000 / $1,500,000, or 6.33%.
The debt service coverage ratio is the net operating income divided by annual debt service. While it may appear that the total debt service is a static input into this formula, the DSCR can in fact also be manipulated. This can be done by simply lowering the interest rate used in the loan calculation or by changing the amortization period for the proposed loan. For example, if a requested loan amount doesn’t achieve a required 1.25x DSCR at a 20-year amortization, then a 25-year amortization could be used to increase the DSCR. This also increases the risk of the loan, but is not reflected in the DSCR or LTV.
As you can see, the amortization period greatly affects whether the DSCR requirement can be achieved. Suppose that in order for our loan to be approved, it must achieve a 1.25x DSCR or higher. As demonstrated by the chart above, this can be accomplished with a 25-year amortization period, but going down to a 20-year amortization breaks the DSCR requirement.
Assuming we go with the 25-year amortization and approve the loan, is this a good bet? Since the debt yield isn’t impacted by the amortization period, it can provide us with an objective measure of risk for this loan with a single metric. In this case, the debt yield is simply $90,000 / $1,000,000, or 9.00%. If our internal policy required a minimum 10% debt yield, then this loan would not likely be approved, even though we could achieve the required DSCR by changing the amortization period.
Just like the amortization period, the interest rate can also significantly change the debt service coverage ratio.
As shown above, the DSCR at a 7% interest rate is only 1.05x. Assuming the lender was not willing to negotiate on amortization but was willing to negotiate on the interest rate, then the DSCR requirement could be improved by simply lowering the interest rate. At a 5% interest rate, the DSCR dramatically improves to 1.24x.
This also works in reverse. In a low-interest rate environment, abnormally low rates present future refinance risk if the rates return to a more normalized level at the end of the loan term. For example, suppose a short-term loan was originally approved at 5%, but at the end of a 3-year term rates were now up to 7%. As you can see, this could present significant challenges when it comes to refinancing the debt. The debt yield can provide a static measure of risk that is independent of the interest rate. As shown above, it is still 9% for this loan.
Market valuation, amortization period, and interest rates are in part driven by market conditions. So, what happens when the market inflates values and banks begin competing on loan terms such as interest rate and amortization period? The loan request can still make it through underwriting, but will become much riskier if the market reverses course. The debt yield is a measure that doesn’t rely on any of these variables and therefore can provide a standardized measure of risk.
Suppose we have two different loan requests, and both require a 1.20x DSCR and an 80% LTV. How do we know which one is riskier?
As you can see, both loans have identical structures with a 1.20x DSCR and an 80% LTV ratio, except the first loan has a lower cap rate and a lower interest rate. With all of the above variables, it can be hard to quickly compare the risk between these two loans. However, by using the debt yield, we can quickly get an objective measure of risk by only looking at NOI and the loan amount:
As you can see, the first loan has a lower debt yield and is therefore riskier according to this measure. Intuitively, this makes sense because both loans have the same NOI, except the total loan amount for Loan 1 is $320,000 higher than Loan 2. In other words, for every dollar of loan proceeds, Loan 1 has just 7.6 cents of cash flow versus Loan 2 which has 10.04 cents of cash flow.
This means that there is a larger margin of safety with Loan 2, since it has higher cash flow for the same loan amount. Of course, underwriting and structuring a loan is much deeper than just a single ratio. There are other factors that the debt yield can’t consider such as guarantor strength, supply and demand conditions, property condition, strength of tenants, etc. However, the debt yield is a useful ratio to understand, and it’s being utilized by lenders more frequently since the financial crash in 2008.
The debt service coverage ratio and the loan to value ratio have traditionally been used (and will continue to be used) to underwrite commercial real estate loans. However, the debt yield can provide an additional measure of credit risk that isn’t dependent on the market value, amortization period, or interest rate. These three factors are critical inputs into the DSCR and LTV ratios, but are subject to manipulation and volatility. The debt yield on the other hand uses net operating income and total loan amount, which provides a static measure of credit risk, regardless of the market value, amortization period, or interest rate. In this article, we looked at the debt yield calculation, discussed how it compares to the DSCR and the LTV ratios, and finally looked at an example of how the debt yield can provide a relative measure of risk.
Source: How to Calculate The Debt Yield Ratio
https://www.creconsult.net/market-trends/how-to-calculate-the-debt-yield-ratio/
The Debt Service Coverage Ratio, often abbreviated as “DSCR”, is an important concept in real estate finance and commercial lending. It’s critical when underwriting commercial real estate and business loans as well as tenant financials, and it is a key part in determining the maximum loan amount. In this article, we’ll take a deep dive into the debt service coverage ratio, explain what a DSCR loan is, and walk through several examples along the way.
The debt service coverage ratio (DSCR) measures the ability of a borrower to repay its debt. The DSCR is widely used in commercial loan underwriting and is a key formula lenders use to determine the size of a loan.
The debt service coverage ratio formula depends on whether a loan is for real estate or a business. While the logic behind the DSCR formula is the same for both, there is a difference in how it is calculated.
For commercial real estate, the debt service coverage ratio (DSCR) definition is net operating income divided by total debt service:
For example, suppose Net Operating Income (NOI) is $120,000 per year and total debt service is $100,000 per year. In this case, the debt service coverage ratio (DSCR) would simply be $120,000 / $100,000, which equals 1.20. It’s also common to see an “x” after the ratio. In this example, it could be shown as “1.20x”, which indicates that NOI covers debt service 1.2 times.
For a business, the debt service coverage ratio definition is EBITDA divided by total debt service:
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. For example, if EBITDA for a company was 240,000 for the last fiscal year, and total debt service was 141,000, then the DSCR would be 1.7x.
Sometimes there will be variation in how the debt service coverage ratio is calculated. For example, capital expenditures are commonly excluded from the DSCR calculation because capex is not considered an ongoing operational expense, but rather a one-time investment. Lenders will have credit policies that define how the debt service ratio is calculated, but there is often still some variation depending on the situation. It’s important to clarify how the DSCR is calculated with all parties involved.
What does the debt service coverage ratio mean? A DSCR greater than or equal to 1.0 means there is sufficient cash flow to cover debt service. A DSCR below 1.0 indicates there is not enough cash flow to cover debt service. However, just because a DSCR of 1.0 is sufficient to cover debt service does not mean it’s all that’s required.
Typically, a lender will require a debt service coverage ratio higher than 1.0x to provide a cushion in case something goes wrong. For example, if a 1.20x debt service coverage ratio was required, then this would create enough of a cushion so that NOI could decline by 16.7%, and it would still be able to fully cover all debt service obligations.
What is the minimum or appropriate debt service coverage ratio? Unfortunately, there is no one size fits all answer and the required DSCR will vary by bank, loan type, and by property type.
However, typical DSCR requirements usually range from 1.20x-1.40x. In general, stronger, stabilized properties will fall on the lower end of this range, while riskier properties with shorter term leases or less creditworthy tenants will fall on the higher end of this range.
The DSCR is critical when sizing a commercial real estate loan. Let’s take a look at how the debt service coverage ratio is calculated for a commercial property. Suppose we have the following Proforma:
As you can see, our first year’s NOI is $778,200 and total debt service is $633,558. This results in a year 1 debt service coverage ratio of 1.23x ($778,200/$633,558). And this is what the debt service coverage ratio calculation looks like for all years in the holding period:
As shown above, the DSCR is 1.23x in year 1 and then steadily improves over the holding period to 1.28x in year 5. This is a simple calculation, and it quickly provides insight into how loan payments compare to cash flow for a property. However, sometimes this calculation can get more complex, especially when a lender makes adjustments to NOI, which is a common practice.
The above example was fairly straightforward. But what happens if there are significant lender adjustments to Net Operating Income? For example, what if the lender decides to include reserves for replacement in the NOI calculation as well as a provision for a management fee? Since the lender is concerned with the ability of cash flow to cover debt service, these are two common adjustments banks will make to NOI.
Reserves are essentially savings for future capital expenditures. These capital expenditures are major repairs or replacements required to maintain the property over the long-term and will impact the ability of a borrower to service debt. Similarly, in the event of foreclosure, a professional management team will need to be paid out of the project’s NOI to continue operating the property. While an owner managed property might provide some savings to the owner, the lender will likely not consider these savings in the DSCR calculation.
Other expenses a lender will typically deduct from the NOI calculation include tenant improvement and leasing commissions, which are required to attract tenants and achieve full or market-based occupancy.
Consider the following proforma, which is the original proforma we started with above, except with an adjusted NOI to account for all relevant expenses that could impact the property’s ability to service debt:
As illustrated by the proforma above, we included reserves for replacement in the NOI calculation, as well as a management fee. This reduced our year 1 NOI from $778,200 down to $728,660. What did this do to our year 1 DSCR? Now the debt service coverage ratio is $728,660 / $633,558, or 1.15x. This is much lower than what we calculated above and could reduce the maximum supportable loan amount or potentially kill the loan altogether. Here’s what the new DSCR looks like for all years in the holding period:
Now when the debt service coverage ratio is calculated it shows a much different picture. As you can see, it’s important to take all the property’s required expenses into account when calculating the DSCR, and this is also how banks will likely underwrite a commercial real estate loan.
The debt service coverage ratio is also helpful when analyzing business financial statements. This could be helpful when analyzing tenant financials, when securing a business loan, or when seeking financing for owner occupied commercial real estate.
How does the DSCR work for a business? The general concept of taking cash flow and dividing by debt service is the same. However, instead of looking at NOI for a commercial property, we need to substitute in some other measure of cash flow from the business available to pay debt obligations. But which definition of cash flow should be used? Given the importance of debt service coverage, there is surprisingly no universal definition used among banks, and sometimes there is even disagreement within the same bank. This is why it’s important to clarify how cash flow will be calculated.
With that said, typically Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) or some form of adjusted EBITDA will be used. Common adjustments include adding back an appropriate capital expenditure amount required to replace fixed assets (which would offset the depreciation add back), and also considering working capital changes (to cover investments in receivables and inventory).
Let’s take an example of how to calculate the debt service coverage ratio for a business.
As shown above, EBITDA (cash flow) is $825,000 and total debt service is $800,000, which results in a debt service coverage ratio of 1.03x. This is found by dividing EBITDA of $825,000 by total debt service of $800,000. This gives us an indication of the company’s ability to pay its debt obligations.
If this analysis were for a tenant, we might want to subtract out existing lease payments and add in the new proposed lease payments. Or, if this were for an owner occupied commercial real estate loan, we would probably subtract out the existing lease payments and add in the proposed debt service on the new owner occupied real estate loan.
Based on the above 1.03x DSCR, it appears that this company can barely cover its debt service obligations with current cash flow. There could be other ways of calculating cash flow or other items to consider, but strictly based on the above analysis, it’s not likely this loan would be approved. However, sometimes looking at just the business alone doesn’t tell the whole story about cash flow and debt service coverage.
Calculating the debt service coverage ratio like we did above doesn’t always tell the whole story. For example, this could be the case when the owner of a small business takes most of the profit out with an above market salary. In this case, looking at both the business and the owner together will paint a more accurate picture of cash flow and also the debt service coverage ratio. Suppose this was the case with the company above. This is what a global cash flow analysis might look like if the owner was taking most of the business income as salary:
In the above analysis, we included the business owner’s personal income and personal debt service. Assuming the owner was taking an abnormally high salary from the business, this would explain the low debt service coverage ratio when looking at the business alone, as in the previous example. In this new global debt service coverage calculation, we take this salary into account as cash flow, as well as all personal debt service and living expenses. Digging into how personal cash flow is calculated is beyond the scope of this article, but most of this information can be found just from personal tax returns, the personal financial statement, and the credit report, all of which will be required by a lender when underwriting a loan.
As you can see, this new global DSCR paints a much different picture. Now global income is $1,575,000 and global debt service is $1,100,000, which results in a global DSCR of 1.43x. This is found by simply dividing global income by global debt service ($1,575,000/$1,100,000). More often than not, a global cash flow analysis like this tells the full story for many small businesses.
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In this article, we discussed the debt service coverage ratio, often abbreviated as just DSCR. The debt service coverage ratio is a critical concept to understand when it comes to underwriting commercial real estate and business loans, analyzing tenant financials, and when seeking financing for owner occupied commercial real estate. We covered the definition of the debt service coverage ratio, what it means, and we also covered several commercial real estate and business examples for calculating the debt service coverage ratio. While the DSCR is a simple calculation, it’s often misunderstood, and it can be adjusted or modified in various ways. This article walked through the debt service coverage ratio step by step to clarify these calculations.
Source: Debt Service Coverage Ratio (DSCR): A Calculation Guide
https://www.creconsult.net/market-trends/debt-service-coverage-ratio-dscr-a-calculation-guide/
When it’s time to close on a commercial real estate transaction, the process can seem overwhelming. This definitive guide will walk you through every step in the commercial real estate closing process. You will see where the commercial process is similar to the residential process, and where things are different. You will also discover the places you need to be cautious and where your due diligence efforts are most important. Commercial real estate has fewer protections for buyers, but also gives parties more room to be creative with deal making.
There are four major steps to closing a commercial real estate deal. Some of these steps are ongoing and others overlap. Every transaction will go through escrow, signing authority verification, due diligence, and signing and processing title and closing documents.
Just like when you purchase a home, escrow is an important part of the commercial real estate closing process. In escrow, a neutral third party will hold funds in an account until either a) all the requirements of the escrow agreement have been met, or b) until one party pulls out of the deal in accordance with the terms of the escrow agreement. Escrow is designed to solve the problem of trust between two parties. Nobody gets paid or receives title to the property until both parties have had their agreed upon conditions met.
Most private home sales have an informal escrow process. Because commercial sales often involve larger sums of money and are more complex, escrow in this setting is formal and tightly controlled. Capital for a commercial transaction will typically come from many sources. Additionally, because there is less regulation of commercial real estate deals, the parties must do more due diligence to protect their investments. The paperwork involved is highly customized and more extensive than the form documents used when buying a home.
The parties will often have negotiated an escrow agreement that the escrow agent must verify has been satisfied before releasing any funds.
While there is no legal requirement for who the buyer and seller must choose to serve as the escrow agent, usually the title agent will act as escrow agent. Title agents are often already familiar with the details of the transaction and have no financial interest in the success or failure of the deal, as their fee is for services rendered regardless of the outcome of the deal. Title agents also have the expertise to create the customized closing documents vital to most commercial real estate transactions.
Before money can be transferred to the escrow agent, the parties have to come to some agreement as to what the escrow agent’s duties are and what will satisfy escrow and allow the funds to be released to the seller of the property.
Unlike residential sales, the escrow agreement in commercial real estate closings is unique for each deal. However, there are several common escrow agreement provisions, such as:
Typically, escrow agents won’t have any responsibility for verification of any part of the deal, apart from only releasing funds when instructed from both the buyer and the seller. Instructions to release the funds are almost always required to be in writing.
Instead of a contract between two people, a commercial real estate deal involves one or more contracts between two or more legal entities. Because these deals are expensive, all parties want to limit their liability and often create legal entities for the sole purpose of owning a piece of commercial real estate. For every entity such as a corporation, LLC, or LLP involved, additional steps must be taken to verify their fitness and ability to conduct the transaction.
One feature of American law is that investors in a corporation are shielded from loss or liability for the actions of the corporation up to the amount of their investment. In other words, if a corporation gets sued the investors may lose their investment in the corporation, but their personal assets will not on the line. This same protection also extends to LLC’s and LLP’s in most states.
Investors know that commercial real estate can come with large risks. Legal entities are used to protect individual investors from liability both as sellers and buyers.
Even existing legal entities buying additional property will sometimes create a new legal entity or subsidiary, to isolate the risk of acquiring or selling a piece of property.
In many states, there are tax advantages to owning commercial real estate in a legal entity.
A corporation or other legal entity may be the actual party to a transaction, but a human being will still need to sign and execute documents of the behalf of the entity. This creates an extra layer of paperwork in the commercial real estate closing process.
Both sides will want proof that the person signing on the dotted line has the authority to do so. This is called signing authority. Proof of signing authority can be in the form of a corporate charter that expressly gives the individual such authority, letters of authorization from the president, CEO, or board of directors of the entity, or a resolution from the board of directors or equity partners.
Until documents demonstrating signing authority have been received, a party will not allow the money in escrow to be disbursed. The seller wants to make sure the buyer has the legal authority to commit to the transaction, and the buyer wants to make sure the seller is legally authorized to dispose of the asset.
Before proceeding too deeply into a commercial real estate deal, you should make sure the proof of signing authority will not be an issue for your legal entity. Here are a few ways to set up authority before entering into a transaction:
By making sure the authority issue is resolved before the closing process, you will save valuable time.
The Real Estate Settlement Procedures Act (RESPA) is the main federal law that governs residential home sales. This law requires sellers to make several guarantees and warranties to buyers about the condition of the property and the absence of a variety of environmental defects. RESPA also governs the form of closing documents that can be used. The purpose of the law is to protect homebuyers from being deceived and buying a house that is dangerous or uninhabitable. RESPA does not apply to commercial real estate transactions.
The lack of RESPA affects commercial real estate closings in two major ways. One, it means that buyers and sellers must perform detailed due diligence on the property and the other parties to the transaction, which can delay the closing of the deal. Two, the lack of RESPA frees the parties to be more creative in structuring the deal and in the types of closing documents they choose to use.
During a commercial transaction, the buyer is constantly trying to preserve the right to withdraw from the deal as long as possible and the seller is trying to limit the right of the buyer to withdraw. Buyers are looking to add contingencies, and sellers are looking to close all contingencies long before escrow and the closing process. The buyer is also trying to keep the seller on the hook for any problems that become apparent after the sale for as long as possible, while the buyer wants to terminate its liability as close to the closing date as possible. These tensions are reflected in the due diligence process and the form of the closing documents.
Because there are fewer state and federal protections for buyers and sellers in a commercial real estate transaction, the due diligence process is much more extensive.
Buyers will want to make sure the following areas are in order:
Sellers will want to make sure the following are in order:
Every transaction is different, and certain deals may require even more steps in the due diligence process than those discussed above.
In addition to the due diligence procedures discussed above, both parties will want to make sure all the closing documents are reviewed for accuracy and properly executed on time.
In residential real estate transactions, RESPA requires use of a specific form for all closing documents. In the commercial real estate closing process, the parties are free from the RESPA requirements and can draft the closing documents as they see fit. This will often cause some back and forth as the parties negotiate over the exact form the documents will take, but it also gives the parties more flexibility to get a deal done that both sides can live with.
Before a deal can be completed, the buyer and seller must both agree to accept a title report and execute a series of closing documents. The closing documents may include assignments and assumption of leases, deeds, environmental reports and assignments of liability, zoning disclosures and warranties, and anything else the parties decide is necessary to close the deal.
Earlier in the process of negotiating the transaction, a title company will be hired to issue a preliminary report of the state of the title to the property. Commercial real estate titles are often much more complicated than residential titles. There are any number of liens and encumbrances such as easements that have to be accounted for. Often the seller may no longer hold some of the below ground rights such as mineral or water rights.
Once the preliminary report has been issued, the buyer must carefully review it and file any objections or concerns to the report under a deadline. If the buyer has any objections, the seller often has a limited period of time to respond to the objections of the buyer can walk away from the transaction.
Once all the issues with the title have been settled, the title company will issue the final report. Both the buyer and the seller will then review this report for errors or concerns, and any issues will have to be resolved before the transaction can move forward.
Buyers will want reassurances that the property is correctly zoned for its current use and for the buyer’s intended use. As part of the closing documents, the parties will want a report that proves a zoning and building jacket search have been conducted and that there are no known zoning issues. Depending on the jurisdiction, this report may include letters from the local municipalities, endorsements to the title of the property, or a detailed report from the title company.
Because liability for environmental problems can be so severe, the parties will usually require a separate report and document to deal with the current understanding of environmental issues, such as a known wetland or known ground or water pollution. The buyer will want some statement from the seller stating the property is otherwise free from issues, and the seller will want to try to avoid making such a statement. A document detailing the final agreement of the parties as to both the nature of any environmental issues and future liability for later discovered issues will be part of most commercial real estate closings.
Like in residential transactions, part of the closing documents will be some form of deed, typically a quitclaim deed, but sometimes a special warranty deed is used. This document once recorded officially transfers ownership of the property from buyer to seller. A title affidavit will also accompany the executed deed.
Federal laws, such as the Patriot Act, also require that a non-foreign entity affidavit be executed with the deed.
The title and the terms of the deed will have been reviewed and discussed long before the formal closing documents are executed.
Unlike in a residential transaction, a commercial real estate closing will include an assignment and assumption of leases. This document explains that the benefits of any lease transfers from the seller to the buyer. It also transfers future liability for breaches of the lease from seller to buyer, and details responsibility for lease breaches prior to the sale. This document also notifies tenants of the change in ownership.
The commercial real estate closing process is more involved and complicated than the residential real estate closing process. Because there is less federal regulation of the process, the parties have greater freedom to structure the deal and the closing documents, but both sides also must exert greater due diligence. Because of the large amounts of money involved and a variety of sources of capital, escrow is more formal and both sides of the transaction are usually legal entities. The closing process takes longer in commercial real estate deals, but there are more tools to resolve issues than in residential purchases. This article gave a broad overview of the commercial real estate closing process, but as always, it’s best to consult a competent real estate attorney to discuss your particular situation.
Source: Commercial Real Estate Closing Process: The Definitive Guide
https://www.creconsult.net/market-trends/commercial-real-estate-closing-process-the-definitive-guide/
