Understanding Debt Yield and DSCR
Commercial real estate lenders rely on two primary metrics to evaluate risk and determine loan sizing: Debt Service Coverage Ratio (DSCR) and Debt Yield. While DSCR has been a standard underwriting metric for decades, Debt Yield became a primary risk control following the 2008 financial crisis.
Debt Service Coverage Ratio (DSCR) measures the property's cash flow relative to its annual mortgage payments (debt service):
$$\text{DSCR} = \frac{\text{Net Operating Income (NOI)}}{\text{Annual Debt Service}}$$
A DSCR of 1.25 means the property generates 25% more operating income than is required to pay the mortgage. LPs and lenders typically require a minimum DSCR of 1.20 to 1.35.
Debt Yield measures the lender's return if they had to foreclose and take ownership of the property immediately. It is calculated by dividing annual NOI by the loan amount, completely ignoring interest rates and amortization terms:
$$\text{Debt Yield} = \frac{\text{Net Operating Income (NOI)}}{\text{Loan Amount}} \times 100$$
Because Debt Yield is independent of interest rates, it prevents borrowers from inflating loan sizes during low-rate environments, protecting lenders from over-leveraging.