Real estate developers can make money in a few ways. They can construct new buildings, homes or apartments and then sell them for a profit. Or they can rehabilitate existing structures for resale. A third method of extracting value from real estate is to rent it. Borrowers and lenders use debt yield to quantify the maximum size of a property loan, or mortgage, based upon the income a property produces.
Net Operating Income
The formula for a property's debt yield is the ratio of its net operating income, or NOI, to the size of the mortgage loan. NOI is the rental income earned by a property minus the direct costs of operating the property. These costs include salaries, maintenance supplies, insurance, utilities and marketing. Taxes and interest cost are not part of NOI. Lenders gauge the size and stability of NOI when deciding the amount they will allocate to a property mortgage.
Calculating the Ratio
The calculation is straightforward. As an example, suppose a property generates $5 million a year and the developer requests a $35 million mortgage. The debt yield ratio is 14.29 percent, which is $5 million divided by $35 million. Lenders set a minimum debt yield, often 10 percent, before approving a mortgage. Higher ratios reduce the risk that the developer will default on a mortgage payment. Different lenders set different minimum debt yields, and the required yield can vary when interest rates rise or fall.
The loan-to-value, or LTV, ratio is related to the debt yield as a measure of a lender's risk. The value of a property is the amount it would bring at auction. A 10 percent debt yield translates into an LTV between 63 and 70 percent. Should a property developer default on its mortgage, the lender assumes title to the property and then either holds or sells it. A high debt yield makes it more attractive for a lender to collect rents rather than lock in a loss through a sale of the property.
Many property loans are securitized, or grouped into mortgage pools that back bonds sold to investors. The debt yield is one of several mortgage pool characteristics that investors evaluate when they bid on mortgage-backed securities. However, investors look beyond debt yield, examining the creditworthiness of the property owners and the average mortgage terms within the pool. In the frenzied mortgage market preceding the real estate meltdown of 2008, debt yields plummeted below 10 percent and LTV ratios soared, rising as high as 82 percent.