Why Community Banks Should Adopt A Minimum Debt Yield Ratio

Enhancing CRE Underwriting -Picture of a industrial building

In one of our blogs last week, we discussed why real estate loans originated today at 1.20X DSCR and 75% LTV may quickly become substandard credits if cap rates normalize, interest rates rise to long-term averages, or NOI is stressed in an economic downturn.  We argued that community banks should be favoring 1.50X DSCR credits, as that is the minimum cash flow required to withstand a standard recession.  We also stated that lenders must incorporate a minimum debt yield ratio at origination of the loan.   In this late period of the business cycle, a minimum debt yield will protect lenders better than DSCR and LTV standards.  In this blog, we will analyze how a debt yield ratio can help community banks properly measure the interplay between cap rates, interest rates, and cash flow.

What is Debt Yield Ratio

The debt yield ratio is a property’s NOI divided by the property’s debt.  For purposes of our discussion, we will assume that there is no mezzanine or subordinated debts associated with the property.  Debt yield measures the cash-on-cash return on the bank’s investment.  Debt yield overcomes the inherent weakness of DSCR and LTV calculations late in a business cycle.  Debt yield is not subject to changes in the amortization schedule, interest rates, cap rates, or other variables that can temporarily increase real estate values.  The only factor the debt yield considers is how large a loan the bank can extend compared to the property’s NOI.

The best way of demonstrating the different conclusions that lenders can reach between underwriting to DSCR and LTV, versus including debt yield is through some specific loan analysis. 

Consider a $1.6mm loan ($2.25mm appraised value), 25 due 10, 1.22X DSCR, and 71% LTV, priced at 4.75%.  All the parameters of this loan are listed in the table below and note that the loan has an 8.4% debt yield ratio ($135k divided by $1.6mm).

Calculation of Debt Yield

 

That is a standard commercial real estate loan in today’s community bank market.  However, this loan structure is fraught with credit problems for a host of reasons.  For example, if NOI declines 15% (not a severe scenario) the DSCR falls below 1.0X and LTV (assuming the same cap rate) increases to 85%.  If the cap rate increases from 6% to 8% (returning to historical averages) the LTV increases from 71% to 96%.  If interest rates increase by 2.00% (a standard interest rate stress test), the DSCR falls to 1.0X.  What appears to be a standard and safe bank loan can become a problem credit when subjected to credit stress from just one of the above parameters.  It becomes a worse outcome if some of the above parameters are correlated and move in tandem against a lender’s interests.

Now let us consider the same loan but assume that the bank had a 10% minimum debt yield ratio.  We solved for the parameters for this loan to obtain a minimum 10% debt yield as shown in the table below.

Debt Yield Calculation - Part 2

 

How does this loan compare to the first one under various credit stress scenarios?  We analyzed the data to compare the two loans with various assumptions and present them graphically below.

We first analyzed the impact of changes in NOI on LTV.  In the graph below NOI changes are shown in 5% increments (both increases and decreases) starting at the base $135k level (marked by the yellow vertical line).

 Net Operating Income To LTV Graph

The loan with a 10% debt yield ratio in the green line can endure 15% more NOI decrease to breach 100% LTV compared to the loan with 8% debt yield ratio in red. 

Next, we compared NOI decreases against DSCR levels.

Net Operating Income to Debt Service Coverage Graph

 

The loan with a 10% debt yield ratio can withstand twice the NOI decline to breach 1.0X DSCR compared to the loan with an 8% debt yield ratio. 

Next, we considered the sensitivity of LTV to cap rates for the two loans as shown below.

Cap Rate To LTV Graph

For the loan with 8% debt yield, if cap rates for this property move from current level of 6% to 8.40% (not an extreme case), the LTV surpasses 100%.  The loan with a 10% debt yield can show sub 100% LTV up to 10% debt yield.

We then considered the sensitivity of DSCR to movement in interest rates for the two loans as shown below.

Loan Rate To DSCR Graph

Not surprisingly, the 8% debt yield loan demonstrates sub 1.0X DSCR if rates move up by 201bps.  The 10% debt yield loan can maintain 1.0X DSCR to 400bps increase.

Finally, we considered the sensitivity of DSCR to changes in different amortization periods as shown below.

 Amortization to DSCR Graph

While the 8% debt yield ratio loan results in a 1.07X DSCR with a 20-year amortization period, the 10% debt yield loan can repay the debt over a 13-year period. 

How to Apply at Your Bank

Banks should be including minimum debt yield ratios in their underwriting standards.  Unlike DSCR or LTV, debt yield is not affected by longer amortization schedules, low-interest rates, low cap rates, or any other variable that can temporarily increase real estate values and the associated risk to creditors.  Looking for minimum debt yield is especially important for lenders this late in the business cycle.  There is, of course, one trade-off to targeting 10% debt yield real estate loans – lower loan rates.  But the trade-offs are well worth it and result in higher risk-adjusted loan ROE.