In this post we are looking at some popular key performance indicators (KPIs) that lenders use.
Key Performance what?
Let’s just have a quick thought about KPIs: A simple definition of what KPIs are can be found on Wikipedia:
A performance indicator or key performance indicator (KPI) is a type of performance measurement. KPIs evaluate the success of an organization or of a particular activity (such as projects, programs, products and other initiatives) in which it engages.
So, put in very simple terms we are talking about a very important indicator. There is not a standard, or definitive set of KPIs, however you might already use your personal KPIs all the time when you look at a real estate investment (think of purchase price per sqm, multipliers etc). These are all KPIs. By now you can already see that KPIs are derived from cash flows. If you think in terms of Profit and Loss Statements, an EBIT Margin is an example of a widely known key performance indicator. In the first Analysis of a real estate investment #1 we already came across several KPIs such as IRR or equity multiple.
Now that we are all on the same page what key performance indicators are, I am going to present you a top 3 list of the most important KPIs that banks use when evaluating your potential real estate investment.
Number 3: Debt Yield
Debt Yield is a ratio to measure how much debt service the cash flow can tolerate.
To calculate the debt yield we divide the net operating income (NOI) by the total outstanding debt.
Let’s use an example for clarification:
We assume that our real estate generates a net operating income of € 5,000 in year 0. The NOI grows by 2.0% each year and our forecasting period is 5 years.
Further, we assume that we finance the property with a loan of € 100,000. The interest rate is set to 1.5% p.a. with a linear amortization of 2.0% p.a. This results in an initial debt service of 3.5% (1.5% interest + 2.0% amortization). After reducing the NOI by the interest and amortization we get a cash flow after debt service.
The concept of the debt yield assumes that we use our total NOI as a debt service. In year 1 we have a debt yield of 5.1%. This is calculated by dividing the NOI of € 5,000 by the outstanding debt at the end of year 1 of € 98,000.
With a debt yield of 5.1% we could increase the amortization from 2.0% p.a. to 3.6% p.a. given that the interest rate of 1.5% p.a. remains the same (1.5% interest + 3.6% amortization = 5.1% debt service).
Or put the other way round, our interest rate could increase from 1.5% p.a. to 3.1% p.a. given that the amortization remains the same at 2.0% p.a. (3.1% interest + 2.0% amortization = 5.1% debt service).
Banks like to calculate the debt yield because the ratio enables them to better understand the downside risk of a transaction. A high debt yield indicates that there is ample cash flow for any unexpected events. Emphasis is often placed at the debt yield during the last year of a financing (in our example year 5). In case a refinancing occurs at the end of the current financing, a high debt yield ensures enough headroom for higher interest rates. This is especially true for the current low interest environment.
What you should look for in a debt yield?
- A higher debt yield indicates less risk and vice versa.
- An increasing debt yield is better than a decreasing debt yield.
- The debt yield at the end of your last year of financing is highly important if you plan to refinance.
- Be proactive when you notice that your debt yield might not be sufficient. Think of a savings period to cover either for some underfunding, or as a cash cushion to put banks in a good mood.
Further reading material
An excellent post about how to calculate the debt yield ratio is published at PropertyMetrics. They go into much more detail and compare the debt yield ratio to other ratios as well.
I am going to publish the second most important KPI next week. The number 1 KPI follows shortly thereafter.
Can you guess about which KPIs I am going to talk about?