Loan Sizing in Real Estate: LTV, DSCR and Debt Yield
Lenders size a real estate loan to the lowest of several tests. A worked example shows how LTV, DSCR and debt yield produce the binding constraint.
Key takeaways
- Lenders size to the lowest of LTV, DSCR and debt yield, plus loan-to-cost on construction.
- In the example, 65% LTV gives $10.40M, 1.25x DSCR gives about $10.55M and 9% debt yield about $11.11M, so LTV binds.
- At a 7.5% rate the DSCR test falls to about $9.53M and becomes the binding constraint.
A real estate lender does not pick one ratio and lend against it. The loan is sized to the lowest amount produced by several tests at once - usually loan-to-value, debt service coverage ratio and debt yield. Whichever test gives the smallest loan is the binding constraint, and it changes as interest rates move.
The three tests
- Loan-to-value (LTV): the loan as a percentage of appraised value. It protects the lender if the property has to be sold.
- Debt service coverage ratio (DSCR): net operating income divided by annual debt service. It tests whether income can carry the payments.
- Debt yield: net operating income divided by the loan amount. It ignores interest rate and amortisation, so it cannot be flattered by loan terms.
A worked example
A property produces $1,000,000 of net operating income and is valued at $16,000,000, a 6.25% cap rate. The lender's limits are 65% LTV, 1.25x DSCR and a 9.0% debt yield. The loan is priced at 6.5% with 30-year amortisation.
- LTV test: 65% of $16,000,000 = $10,400,000.
- DSCR test: maximum debt service is $1,000,000 / 1.25 = $800,000 a year. At 6.5% over 30 years the annual payment is about 7.58% of the loan, so the loan is about $10,550,000.
- Debt yield test: $1,000,000 / 9.0% = about $11,110,000.
The lowest figure wins. The loan is $10,400,000 and LTV is the binding constraint.
What happens when rates rise
Reprice the same loan at 7.5%. The annual payment rises to about 8.39% of the loan, so the DSCR test now supports only about $9,530,000. Nothing about the property has changed, but the loan has fallen by roughly $870,000 and DSCR has replaced LTV as the binding test. The borrower has to fund the difference with equity.
Construction loans add loan-to-cost
For development, lenders also test loan-to-cost (LTC): the loan as a percentage of total project cost. A project can pass on value and still be constrained by cost, particularly where the appraised completed value is well above the budget.
How to build this into a model
Calculate each test separately on a visible sizing sheet, take the minimum, and show which constraint is binding. Then sensitise net operating income, the interest rate and the cap rate so the borrower can see how much headroom exists. Our acquisition models and development pro formas size debt this way. For coverage in a small business lending context, see what SBA lenders check on DSCR.
Frequently asked questions
What is debt yield?
Debt yield is net operating income divided by the loan amount. A $1,000,000 income and a $10,000,000 loan give a 10% debt yield. Lenders like it because it does not depend on the interest rate or amortisation period.
What DSCR do commercial real estate lenders require?
Requirements vary by lender, property type and market. Figures around 1.20x to 1.35x are common for stabilised commercial property, with higher requirements for riskier assets. Always confirm with the lender.
Why did my loan amount fall when nothing about the property changed?
Because the DSCR test depends on the interest rate. When rates rise, the same income supports less debt service, so the maximum loan under that test falls even if the value is unchanged.