Yield is another term for the return. For example, the yield of a bond is the nominal or coupon rate of interest divided by the purchase price. In commercial property investment, debt yield is a measure of the risk inherent in a loan and has replaced the previous yardstick of loan-to-value.
In the past, lenders calculated the amount they were prepared to lend as a percentage of the property's value. Before 2000, the typical loan-to-value ratio was 70 percent, so a property valued at $1 million could attract a loan of up to $700,000. During the period from 2003 to 2007, competition from bond investors looking for good commercial property investments pushed the loan-to-value ratio as high as 82 percent, and property prices rose significantly. When the value of property began to fall, borrowers owed more than their properties were worth, a situation known as negative equity.
Net Operating Income
The net operating income of a commercial property is the gross income received from the property each year minus operating expenses. Gross income includes all income from the property, such as rental income, parking fees and receipts from vending machines. Operating expenses do not include any capital expenditure or interest on the purchase of the property, but do cover items such as insurance, repairs, maintenance and utilities. The NOI of a property is equivalent to the net profits of a business and is an important factor in key investment ratios.
Debt Service Coverage Ratio
The debt service coverage ratio measures the extent to which income from the property covers its operating expenses and mortgage payments. To calculate it, divide the net operating income by the total mortgage payments for the year. A result of 1 is break even, and most lenders ask for a minimum debt coverage ratio of 1.1 for commercial loans and as high as 1.3. In practice, this means that if the mortgage costs of a property total $300,000 a year, the NOI must be at least $330,000 and preferably $390,000.
Debt Yield Ratio
Debt yield ratio and debt service coverage ratio have become the most important factors commercial mortgage lenders consider when deciding whether to invest in a property. The debt yield ratio shows the NOI as a percentage of the total loan amount, so a loan of $10 million and an NOI of $1 million produces a debt yield ratio of 10 million divided by 1 million, or 10 percent. The higher the debt yield ratio, the more attractive the investment to the lender. Most mortgage providers set a minimum debt yield ratio of 10 percent, but some insist on 11 or 12 percent in a volatile market.