The conventional wisdom links the Canadian economy in lockstep with the U.S. economy, i.e., what happens in the U.S. happens immediately in Canada and frequently with an exaggerated bump.  It’s interesting, therefore, that the Canadian economy is now nine months into recovery from its mildest and shortest recession in the recent past while the U.S. struggles to emerge from its most severe and enduring recession since the Great Depression roughly 80 years ago.

One apparent reason for the dramatically divergent recovery experiences in the two economies is a marked difference in financial regulation and public policies in the decade long run-up to the housing bust.  Canadian regulators kept a very tight lid on speculative banking activities, particularly subprime residential lending.  U.S. regulators did not.  Further, Canada managed its public finances far more prudently than did the U.S. over the run-up period. 

Today the Canadian residential housing market is quite robust.  Housing prices have never been higher, which is in great contrast to the current status of housing prices in the U.S. 

The Canadian economy has benefited, too, from recent external demand for its minerals, oil, and gas.  But at the end of the day, the Canadian economy’s recover is a tribute to effective financial regulation and conservative monetary and fiscal policy in the bubble years – two pillars of public policy long and fatally absent in the U.S. economy under our self regulating philosophy.

The debt yield is a new underwriting metric presumably gaining momentum within the commercial real estate field.  It’s defined as the current net operating income (NOI) for an income producing property divided by the amount of interest bearing debt on the property.

The debt yield is gaining attention for a couple of reasons.  The old standby loan-to-value (LTV) underwriting standard is losing favor and credibility because of the fluctuations in value and general uncertainty about any appraisal in today’s environment.  And, since cash flow repays loans, why not focus on a financing metric, such as the debt yield?  A higher debt yield translates to greater certainty that the property can throw off sufficient cash to meet the debt service…and vice versa.

But is the debt yield really so useful?  We would all agree that a 12% debt yield provides more comfort about sufficient property NOI than a 10% debt yield.  But, as we all know, debt service does not depend on the debt amount alone.  It also depends on the interest rate, the amortization period, and the payment frequency.

The table below provides a combination of debt yields and debt service coverage ratios over a range of term debt amounts financed at 6.00% interest with a 25 year amortization schedule and equal monthly payments.

                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

NOI	Loan Amount	Debt Yield	Debt Service	DSC
$1,200,000	$10,000,000	12.00%	$773,162	1.55
$1,200,000	$10,500,000	11.43%	$811,820	1.48
$1,200,000	$11,000,000	10.91%	$850,478	1.41
$1,200,000	$11,500,000	10.43%	$889,136	1.35
$1,200,000	$12,000,000	10.00%	$927,794	1.29

If we use the debt yield as our guide, we’re back where we started when LTV was the initial underwriting standard.  In effect, we begin with a minimum debt yield and determine if the debt service on that amount of term debt meets or exceeds the DSC underwriting standard.  In this instance, our preferred debt yield of 12% translates to term debt of $10,000,000 with annual debt service of $773,162 and a DSC of 1.55.  What could be better?

Many dollars of interest income, as it turns out.  Let’s assume the lender’s standard DSC minimum is 1.35.  Given our table above, the lender would be willing to provide $11,500,000 of term debt rather than the $10,000,000 dictated by a debt yield of 12%.  But if the debt service on an $11,500,000 term loan meets the underwriting standards, why give up interest income on $1,500,000?  Yet that’s exactly what we would do if we allowed our debt yield guideline to determine the amount of term debt.

It may be attractive to start the underwriting process with a preferred debt yield.  But one way or another, you’ll very likely work your way to a term debt amount whose debt service just matches or exceeds your required DSC minimum.  So why bother with a debt yield at all?