Market leasing assumptions define what happens after a tenant lease expires in a commercial property. Since it’s unknown whether the tenant will renew its lease or not, there are two sets of assumptions. One set of assumptions is used if a new tenant needs to be found. The second set of assumptions is used if an existing tenant renews its lease. Then, there is a renewal probability that creates a weighted average between these two sets of assumptions.
At a high level, the concept of market leasing assumptions is easy to understand. However, with multiple leases, complex assumptions, and various levels of uncertainty, even seasoned commercial real estate professionals can get stuck or confused. In this article, we’ll take a deep dive into market leasing assumptions, dispel some common misconceptions, and then tie it all together with some relevant examples.
To motivate our discussion, let’s start with a simple case study for an office building analysis. Suppose we have a 15,000 square foot building with an analysis start date of January 1st, 2017 and the following rent roll:
There is a large tenant occupying 7,500 square feet, a medium sized tenant occupying 5,000 square feet, and small tenant occupying 2,500 square feet. The large tenant’s lease expires in 3 years on December 31st, 2019. The medium sized tenant’s lease expires a year later on December 31st 2020. And the small tenant’s lease expires one more year later on December 31st, 2021. The first two tenants have annual rent escalations of 3%. The third tenant also has annual rent escalations of 3%, but only for the second and third years of its lease. To keep things simple, there are no reimbursements, leasing commissions, or tenant improvements.
For our expenses we will assume the following:
So, based on the above assumptions, this is what a first draft 10 year proforma looks like with an analysis start date of January 1st, 2017:
As you can see, starting in year 4, there is a significant amount of lease rollover risk with this property. We have one lease expiring in year 4, another in year 5, and yet another in year 6. What happens after these leases expire and how do we account for this in our analysis? Let’s take a closer look at how market leasing assumptions can help.
Before we complete our analysis above, let’s first take a closer look at how market leasing assumptions work. There are two possibilities after a lease expires: 1) the tenant vacates and you have to re-lease the space at the then prevailing market rents and terms, or 2) the tenant renews its lease, possibly at rent and terms different than the market.
Since it’s unknown which of these two outcomes will occur (vacate or renew), “market leasing assumptions” take into account both outcomes. Both scenarios are taken into account by calculating a weighted average between the two outcomes based on a “renewal probability” you enter, which is just your best guess on a scale of 1-100 of the chance a tenant will renew its lease. This results in a blended market/renewal calculation that is ultimately used in the proforma cash flows to account for the uncertainty of tenant renewal.
For example, if you enter a 100% renewal probability then all market inputs will be ignored and only the renewal inputs will be used in the analysis. Likewise, if you enter a 0% renewal probability, then it’s assumed the tenant will certainly NOT renew its lease and therefore all renewal inputs will be ignored and only market inputs will be used.
If you aren’t certain that the tenant will renew or vacate, then you can enter a renewal probability somewhere between 0% and 100%, and the market leasing assumptions will calculate a weighted average between the two possible outcomes. Let’s take a closer look at how this works.
For example, suppose you believe there is a 50% chance the tenant will renew its lease. In either case, here are the market rent/terms and renewal rent/terms:
| Market | Renewal | Blended (50%) | |
| Rent | $10/SF | $9/SF | $9.50/SF |
| Leasing Commissions | 5% | 0% | 2.5% |
| Tenant Improvements | $25,000 | $5,000 | $15,000 |
| Free Rent | 6 months | 0 months | 3 months |
| Months Vacant | 3 months | 0 months | 1.5 months |
As you can see in the above table, the market rent and terms are different than the renewal rent and terms. The renewal assumptions are often at a discount to the market assumptions because renewing a tenant already in place is less costly. To account for this, as well as the 50% possibility that the tenant vacates, the market leasing assumptions create a weighted average between the market and the renewal assumptions. In this case each set of assumptions is weighted equally at 50%, and the result is shown in the “Blended” column above. Let’s take a quick look at each of the line items above, plus some additional market leasing assumptions.
Rent – This is simply the base rent expected for either a new tenant at the market rate, or an existing tenant renewing its lease.
Leasing Commissions – This is the leasing commission paid to find a new tenant at the market rate, or to renew an existing tenant lease.
Tenant Improvements – This is an amount provided by the landlord to the tenant for improvements to the tenants space.
Free Rent – This is the abatement or free rent concession sometimes used to attract a new tenant.
Months Vacant – This defines the downtime after a lease expires if you need to go to the market to find a new tenant. There is no Renewal input for months vacant because if a tenant renews its lease there is by definition no downtime.
In addition to the above weighted inputs, there are also several non-weighted market inputs commonly used. These non-weighted inputs are not affected by the renewal probability. Let’s take a quick look at the non-weighted market leasing assumptions.
Market Lease Term – Once the market/renewal lease begins, the market term defines how long the market/renewal lease lasts in years. This will also affect the timing of the market/renewal leasing commission, tenant improvements, and rent increases that occur within market term itself. After a market term expires all market leasing assumptions reset for the next market term.
Rent Increases – This is the annual rent escalation applied over the market lease term. This will apply to the blended market/renewal and is based on the market term.
Market Inflation – The general market inflation factor is applied to all market and renewal rent entered. The market and renewal inputs are as of the analysis start date and any market inflation entered will apply each year on the anniversary of the analysis start date. When a lease expires, market leasing assumptions will automatically calculate the then prevailing market/renewal rent, which will include any market inflation up to that point in time. This is not to be confused with market rent increases, which simply define the annual escalation factor inside of a market lease term.
Market Reimbursements – The market reimbursements work just like lease reimbursements and will apply no matter what renewal probability is entered.
Now that we’ve covered how market leasing assumptions work, let’s apply some market leasing assumptions to our office building case study to complete our analysis.
Now that we’ve covered how market leasing assumptions work, let’s wrap up our office building analysis from above. Suppose we have the following 3 sets of market leasing assumptions, one for each tenant:
| Market | Renewal | Blended (50% renewal probability) | |
| Rent | $14/SF | $12.60/SF (10% discount) | $13.30/SF |
| Leasing Commissions | 5% | 0% | 2.5% |
| Tenant Improvements | $25,000 | $0 | $12,500 |
| Free Rent | 6 months | 0 months | 3 months |
| Months Vacant (Downtime) | 0 months | 0 months | 0 months |
| Market | Renewal | Blended (75% renewal probability) | |
| Rent | $14.50/SF | $13.05/SF (10% discount) | $13.41/SF |
| Leasing Commissions | 5% | 0% | 1.25% |
| Tenant Improvements | $20,000 | $0 | $5,000 |
| Free Rent | 6 months | 0 months | 1.5 months |
| Months Vacant | 0 months | 0 months | 0 months |
| Market | Renewal | Blended (25% renewal probability) | |
| Rent | $15/SF | $13.50/SF (10% discount) | $14.63/SF |
| Leasing Commissions | 5% | 0% | 3.75% |
| Tenant Improvements | $10,000 | $0 | $7,500 |
| Free Rent | 6 months | 0 months | 4.5 months |
| Months Vacant | 4 months | 0 months | 3 months |
To keep things simple, let’s assume for all 3 tenants that there are no market reimbursements and that all market terms are 5 years. However, we will assume a market inflation factor of 3% for all three tenants as well as 3% rent increases during the market term.
Recall that the difference between the market inflation factor and the market rent increases is that the rent increases apply during the market term while the general market inflation factor is applied to market/renewal rent, which is inputted as of the analysis start date. What happens at lease expiration is the then prevailing market and renewal rent (which could be inflated at the market inflation factor) is calculated and used in the weighted average market/renewal rent calculation. Then, this resulting blended rent calculation is used at the start of market lease term. And during the market lease term the market rent increases will apply each year. Finally, at the expiration of the market lease term this process simply repeats itself.
If this is confusing don’t worry. Let’s break this down step by step. Here’s what the market rent calculations look like for Tenant 1.
Remember that the above market and renewal rent inputs are as of the analysis start date. So, for Tenant 1, a market rent of $14/SF as of the analysis start date with 3% annual market inflation would be a market rent of $15.30 in year 4 . Likewise the renewal rent in year 4 would be $13.77. These calculations are shown in the above table on the first two rows.
The next two rows show the blended market rent for each market term over the holding period. This simply takes a weighted average of the first two lines we calculated above using the renewal probability. Since our renewal probability for Tenant 1 is 50%, the first Blended Rent/SF Term 1 line shows $14.53 per square foot in year 4, which is just (50% x $15.30 + 50% x $13.77). Since our market/renewal lease begins on the first day of year 4, our market rent is $14.53 for the entire year. Then in year 5 our market rent is escalated by the Market Rent Increase assumption of 3%, which results in a market rent per square foot of $15.42. This continues for the entire 5 year market lease term which ends in year 8. This first 5 year market/renewal term is shown in bold above on line 3.
At the end of year 8 our first market terms ends, and in year 9 our second market term begins. At this point in time we need to first figure out what the then prevailing market/renewal rent is, which again, is shown on the first two rows of the table. In this case we can see that our market rent in year 9 is $17.73 and our renewal rent in year 9 is $15.96. And the blended rent assuming a 50% renewal probability is $16.85. This is shown in year 9 for the Blended Rent/SF Term 2 line item. Since we are now in the second market lease term, this starting blended rent is escalated in year 10 by the 3% Market Rent Increase. This process continues for all 5 years of the second market lease term. However, since our analysis period is only 10 years long, only the first two years of the second market lease term are shown.
Now that we’ve walked through the calculations for Tenant 1, let’s see what our proforma looks like when we input market leasing assumptions for all 3 tenants. Using our Proforma Software, this entire analysis took just a few minutes to complete:
As you can see in the completed proforma above, the rental income for Tenant 1 in years 4-10 is exactly what we calculated step by step above. This same process was repeated for Tenant 2 and Tenant 3. You’ll also notice that the market/renewal leasing commissions and tenant improvements are calculated at the start of each market/renewal term. Additionally, free rent is automatically calculated on a separate line item. Finally, for Tenant 3 we assumed there would be 4 months of downtime if we had to find a new tenant for the space. You’ll notice that this is taken into account in the above proforma as well with the Turnover Vacancy line item.
Market leasing assumptions are often a key component in a commercial real estate analysis. However, since there are so many moving parts, market leasing assumptions are often confusing to many commercial real estate professionals. In this article we walked through how market leasing assumptions work, step by step. We also looked at an example office building case study where market leasing assumptions allowed us to make reasonable assumptions about what happens after tenant leases expire.
Source: How Market Leasing Assumptions Work in Commercial Real Estate
https://www.creconsult.net/market-trends/how-market-leasing-assumptions-work-in-commercial-real-estate/
There are a number of reasons why people decide to sell their multifamily property, but most can be categorized into three groups: Problems, Opportunities, and Changes.
With this decision though comes the consideration of capital gains tax and how to ensure you are getting the most for the sale of your property.
There are several reasons why people do sell:
Problems:
Opportunities:
Changes:
There are several options for sellers to defer or minimize capital gains taxes:
We not only market properties for sale. We make a market for properties we represent. Each offering is thoroughly underwritten, aggressively priced, and accompanied by loan quotes to expedite the sales process. We leverage our broad national marketing platform syndicating to the top CRE Listing Sites with direct outreach to our investor database and an orchestrated competitive bidding process that yields higher sales prices.
Contact Us to discuss what information is needed to complete a Complimentary Commercial Broker Opinion of Value (BOV).
This is understandable as only about 5% of the market trades in any given year. We are also happy discuss any purchase or refinance interests and recommend some physical and operational changes you can make to add value to your property you will appreciate when you eventually sell.
eXp Commercial Chicago Multifamily Brokerage focuses on listing and selling multifamily properties throughout the Chicago Area and Suburbs.
We don’t just market properties; we make a market for each property we represent. Each offering is thoroughly underwritten, aggressively priced, and accompanied by loan quotes to expedite the sales process. We leverage our broad national marketing platform syndicating to the top CRE Listing Sites for maximum exposure combined with an orchestrated competitive bidding process that yields higher sales prices for your property.
https://www.creconsult.net/market-trends/why-should-i-sell-my-multifamily-property/
How do you feel about a criminal conviction on your record? Defending against a civil suit for intentional infliction of emotional damage? They don’t sound too bad? Well, how about a fistfight with a tenant on the front lawn of your rental property?
If you’d prefer to avoid these scenarios, it might be a good idea to understand the process required to lawfully evict a tenant. While the details of the eviction process vary from state to state, the general principles discussed here are almost universal. We’ll take a look at:
When a tenant isn’t playing by the rules, when they’re behind in their rent payments, consistently violating lease obligations, it can be extremely frustrating for a landlord. For many there is a desire to just take care of the problem themselves, and figure out a way to get the tenant to leave.
These so-called “self-help” remedies (evicting without using the proper eviction process) include such things as:
These can seem attractive in the short term because they seem quicker and less expensive than a court action. However, because they’re illegal, and often dangerous, in the long-run “self-help” actions can end up being far more time-consuming and costly than simply following the statutory procedure.
Almost every state prohibits a landlord from using self-help methods, and may impose penalties for such, including allowing tenants to remain in possession of the rental property. Further, if a landlord uses these it can be sued for, among other things, trespass, harassment, wrongful eviction, invasion of privacy and intentional infliction of emotional distress. These suits can seek damages caused by the landlord’s unlawful behavior, including not only actual damages (e.g., the cost of a hotel room while the tenant was dispossessed, food gone bad when electricity was turned off, replacing personal property “lost” when the landlord entered the property, etc.) but also punitive damages.
Fighting these types of suits could take years and tens of thousands of dollars. Losing them could be even more costly. The alternative, however, following the statutory eviction procedure, virtually eliminates these hazards.
That being said, let’s take a look at the process.
Let’s take a look at the eviction process, step by step.
Before beginning down the path of an eviction, one must understand that because removing a person from their home is a significant event, the courts will require strict compliance with their eviction laws. This means meet the notice deadlines. Serve the notices in their proper fashion. Name the proper party, etc. If a landlord fails to follow the rules, even the little ones, their action will be delayed.
The first step in the process is the landlord serving its tenant notice that the tenancy is being terminated. The method of service (i.e., its delivery) will be set forth in the state laws, but generally involves methods like personal service to the tenant (hand-delivery), leaving notice at the property with a person of at least a minimum age, or being sent by certified mail to the property.
The notice explains why the landlord is terminating the tenancy, and will fall into one of two categories: (1) termination for cause or (2) termination without cause. Termination for cause means the tenant has failed to meet one or more of its obligations under the lease. The most common failure is not paying rent. Based on the type of default, there are three types of termination notices for cause: (a) pay rent or quit, (b) cure or quit, and (c) unconditional quit.
Pay rent or quit notices notify the tenant they owe rent, how much they owe (including penalties), and when they must make full payment. They have the choice of either paying this amount by the date specified or leave (“quit”) the premises. If they pay, the landlord will stop pursuing eviction. If they do neither, the landlord can then proceed with the eviction process. However, not all states require a pay rent or quit notice. For example, in New Jersey, a landlord can file an eviction complaint for failure to pay rent without first giving his tenant any notice.
Cure or quit notices tell the tenant they have breached one or more of their duties under the lease, and gives them an opportunity to fix (“cure”) the breach. For example, if the lease limited the number of occupants to two, and there were four residents, the tenant could cure by having two people move out. If the tenant doesn’t timely cure, and doesn’t quit, the landlord can proceed with the eviction process. A cure or quit notice should be specific about the breach, and how it can be cured, so the tenant has an opportunity to avoid eviction.
The third “for cause” termination notice, an unconditional quit notice, notifies the tenant that is in breach of one or more lease terms, but has no right to cure. They simply must quit the property by a certain date or an eviction action will ensue. The general thought is that because this is a harsh outcome it should only apply to serious transgressions such as repeatedly failing to pay rent on time, violating significant lease terms, or engaging in illegal activity on the premises. However, not all states agree, and in some cases an unconditional quit notice can be used where other states would require a pay rent or cure notice.
In some cases a landlord may have the right to terminate a lease even where the tenant has done nothing wrong. A typical example is a month-to-month lease, where termination can occur for no reason so long as the tenant is given a 30-day notice. Of course, each state has its own peculiarities. For example, in New Jersey, if a tenant lives in a rental property with three or fewer apartments, and the landlord occupies one of the units, then the landlord doesn’t have to establish any cause for eviction.
Special rules may also apply to publicly or federally-subsidized housing such as Section 8, HUD Housing or the Low-Income Housing Tax Credit (LIHTC) program. For example, landlords cannot evict tenants in LIHTC units without giving notice of specific “good cause” reasons. Good cause is determined on a case-by-case basis, though it may include serious or repeated violations of the lease, crime or drug related activity, or failure to vacate following a condition that leaves the unit uninhabitable.
If the tenant was unresponsive to the termination notice, a landlord may file a “complaint” for eviction with the court. Generally this suit is referred to as an unlawful detainer action. The complaint is the pleading that starts the eviction suit and notifies the tenant of (1) the basis for the court’s jurisdiction, (2) a statement of the eviction claim, (3) the relief being sought by the landlord (e.g., rent, possession, damages), (4) why the landlord is entitled to this relief, and (5) a demand for judgment.
The landlord must serve (in compliance with the state’s laws as to who can serve, and how they must serve) the tenant with a copy of the complaint and a summons. The summons is the official notice that the eviction action has been filed, and generally includes the case number, which court will hear the case, when the tenant must respond to the complaint, and the name of the landlord’s attorney.
The tenant may file an “answer” to the allegations in landlord’s complaint, denying the complaint’s claims, and asserting any defenses it has to the action. The answer must be filed within the time described in the summons.
A common response to a complaint is that the landlord failed to follow the procedural eviction rules in some fashion, e.g., termination notice was improperly served, the complaint named the wrong party, etc. While such responses are easily cured, each failure can add weeks to the eviction process. These responses are typically delay tactics more than defenses, but can be leveraged to negotiate a settlement with a landlord who would like to regain possession of his property sooner rather than later.
Other common defenses include that (1) rent was paid in full prior to filing of suit, (2) landlord failed to maintain property in a safe and habitable state, or failed to comply with all building codes, (3) the eviction is discriminatorily based on race, religion, gender, national origin, familial status or disability, (4) the landlord used impermissible self-help actions, (5) the eviction is retaliatory, and (6) the tenant used rent to offset the cost of repairs it made when the landlord refused to do so itself.
One interesting tenant’s defense is the claim of a “constructive eviction.” This occurs where a tenant alleges that landlord’s failure to take some act (e.g., repair a leaky roof) substantially interferes with or permanently deprives a tenant from using the property. If successful on this claim, a tenant doesn’t have to pay for rent during the period of interference, though most jurisdictions will require the tenant to vacate the premises (you can’t stay if you just proved the property is uninhabitable!).
The court will set a date for trial following receipt of the tenant’s answer. If the tenant failed to answer, the court will award a default judgment and the relief landlord sought in its complaint; typically a judgment for possession and/or damages.
One note to both parties in an unlawful detainer action (well, in any action): Bring evidence to support your claim. For some reason parties to eviction actions seem to believe the other side won’t show, or if they do, they won’t be prepared, and the judge will automatically grant them judgment. Avoid this mindset. Bring evidence the tenant didn’t pay rent (was there correspondence concerning missed payments?). Bring proof of damaged property (are there pictures of the unhinged front door?). Bring the lease, the termination notice, complaints from other tenants. Bring everything.
Following consideration of the evidence, if the landlord prevails it will be awarded a judgment for possession of the property, unpaid rent, and other expenses provided for under the lease.
Once a judgment has been obtained, the landlord provides a copy of it along with a fee to the appointed local law enforcement officer (usually a sheriff). The sheriff posts notice of the date the eviction will occur (as always, this posting must be done in compliance with state law), and if the tenant has not vacated the property before then, the sheriff will remove them. Because law enforcement officers don’t get paid to move couches, typically the landlord will have to provide labor to remove the tenant’s personal property.
While it should be clear from everything we’ve discussed to this point, if the law says that only the sheriff can evict, then the landlord cannot remove the tenant itself, judgment or not. Usually this is express under state law. For example, in New Jersey, the only way a landlord can evict a tenant is if a special court officer with a legal court order, a warrant for removal, comes out himself and does the eviction. Additionally, as noted earlier, self-help actions can be dangerous. Given that evictions can become emotionally charged events, it is in all parties’ best interests to leave this last step to the trained law-enforcement professionals.
Once the tenant’s personal property has been removed, state law will dictate how the landlord must handle it. Some states require the landlord to make a good-faith effort to contact the tenant regarding the property (e.g., mail notice to tenant’s last known address). Others provide the landlord can dispose of the property if the tenant has abandoned the property. Although what constitutes “abandoned” varies by state (many agree that if tenant has not responded to a notice within 30 days, the property is considered abandoned), a general test is whether the tenant clearly has no intent to return to the premises for their property.
Other states don’t require any notice at all. For example, in Georgia if a landlord obtains judgment it is issued a “writ of possession.” The writ is effective seven days after issuance, and after this seven-day period the landlord can dispose of any tenant property left on the premises. He need not notify the tenant. He need not store the property. Seven days in Georgia. Period.
Other states can get a little more complicated, for example, requiring a landlord not only to store property and notify the tenant of the same, but then to dispose or auction off property through public sale (after public notice is made) depending on the value of the property.
Generally state laws provide less protection to tenants in a commercial setting than in a residential one. Not only are people’s homes not in play in a commercial lease, but the courts expect that two commercial parties are less likely to be in a position of unequal bargaining power. They can look out for themselves.
Because of this, some states allow a commercial lease to modify eviction procedures. For example, a lease may include a waiver of the right to a jury. Or, where a cure period under state law is three days, the commercial lease may give a tenant five business days to cure.
Some other common differences include:
While the intricacies vary state by state, evictions follow a similar path no matter where the property is: (1) notice of termination of tenancy, (2) file a complaint and serve tenant with summons and complaint, (3) tenant files answer with defenses, if any, (4) trial and judgment, and (5) notice and eviction by sheriff.
Of course, given that the courts, especially in residential evictions, require strict compliance with the intricacies, that failure to comply can add months, dollars and headaches to an eviction action, and that this discussion is only for informational purposes (and not legal advice), if you have any specific eviction issues, please contact a licensed real estate attorney!
Source: How to Navigate the Real Estate Eviction Process
https://www.creconsult.net/market-trends/how-to-navigate-the-real-estate-eviction-process/
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/
