Credit Analysis

Sizing Debt by DSCR, Debt Yield, LTV and Leverage

Lenders size debt by running several independent constraints, such as debt service coverage, debt yield, loan to value and leverage multiples, and lending the smallest amount any of them allows. Each test protects against a different risk: cash shortfall, low return on loan basis, collateral value decline and excessive leverage relative to earnings.

Why do lenders use more than one sizing constraint?

No single ratio captures every way a loan can fail. A loan can look conservative on value while consuming most of the property's cash flow, or it can be comfortably covered at today's interest rate while sitting on an inflated appraisal. Lenders therefore calculate the maximum loan under each constraint independently and take the lowest result. The constraint that produces the smallest loan is called the binding constraint, and identifying it tells the borrower which lever matters: more income, lower rates, longer amortization or a higher valuation. In practice the binding test shifts with interest rates and cap rates, so it should be rechecked every time terms move.

Sizing also connects directly to structure. If the borrower needs more proceeds than the binding test allows, the gap must be filled with equity, mezzanine debt or preferred equity, or the lender must accept a lower coverage or higher leverage in exchange for higher pricing, faster amortization or additional guarantees. Being explicit about the binding constraint keeps that negotiation honest. A borrower who pushes for a higher loan amount should be able to explain which risk the lender is being asked to accept and why the specific asset or business can tolerate it, rather than simply citing what another lender quoted.

How does debt service coverage size a loan?

The debt service coverage ratio compares net operating income or cash available for debt service with annual principal and interest. To size by coverage, divide cash flow by the minimum required ratio to get the maximum annual debt service, then convert that payment into a loan amount using the mortgage constant for the proposed rate and amortization. Because the payment depends on the interest rate, coverage sizing is the constraint most sensitive to rate movements. When rates rise, the same cash flow supports a smaller loan, which is why coverage often becomes the binding test in a rising rate environment.

Interest only periods and longer amortization increase the loan that coverage will support, but they also slow deleveraging and leave a larger balance at maturity. Lenders often size on an amortizing payment even when the loan is interest only for an initial period, so that the loan remains serviceable once amortization begins. For floating rate loans, coverage should be tested at the higher of the current rate and a stressed rate, or at the strike of any required interest rate cap, because the borrower's payment can rise long before NOI does. Cash available for debt service should also be net of replacement reserves and, for office and retail, a normalized allowance for tenant improvements and leasing commissions.

What is debt yield and why do lenders rely on it?

Debt yield is net operating income divided by the loan amount. It answers a simple question: if the lender took the property back, what unlevered return would it earn on its loan basis? Debt yield ignores the interest rate, the amortization schedule and the appraised value, which makes it hard to manipulate. A low cap rate appraisal or a temporarily low interest rate can inflate loan to value and coverage capacity, but neither changes debt yield. For that reason many commercial real estate lenders use a minimum debt yield as a backstop, especially for larger loans and securitized lending, where it constrains leverage when values and rates are both favorable.

How do loan to value and loan to cost work?

Loan to value divides the loan by the appraised or underwritten value of the collateral. It protects the lender against a decline in asset value and indicates how much equity sits beneath the loan. Loan to cost uses total project cost instead and is common in construction and value add lending, where the current value may not reflect the business plan. The weakness of both ratios is that they rely on a value estimate, and values are themselves a function of cap rates and market sentiment. Disciplined lenders cross check the appraisal against their own underwritten cap rate and size off the lower of the two.

How are leverage multiples used for operating companies?

For operating businesses, the most common sizing tool is a leverage multiple of EBITDA, often split into senior leverage and total leverage. A lender might be comfortable with a given senior multiple for a stable, recurring revenue company and a lower one for a cyclical or concentrated business. Leverage multiples are paired with a fixed charge or interest coverage test, because a multiple alone does not reveal whether the borrower can carry the interest cost. A business with heavy capital spending can look modestly levered on EBITDA while generating little free cash flow to actually reduce debt.

The quality of the EBITDA figure matters as much as the multiple. Lenders size on adjusted EBITDA but scrutinize every addback, and some size on a lower figure that excludes unrealized synergies or one time revenue. Enterprise value matters too: a loan at four times EBITDA on a business worth eight times EBITDA leaves a 50% equity cushion, while the same loan on a business worth five times leaves very little. Lenders therefore look at loan to enterprise value alongside the leverage multiple, and they test how many years of free cash flow it would take to repay the senior debt in full.

How should sizing results be stress tested?

Once the binding constraint is found, the analyst should test how quickly the loan becomes undersized as conditions change. Useful questions include how much NOI or EBITDA can fall before coverage drops to 1.0x, what refinancing rate the property can absorb at maturity, and how far value can decline before loan to value exceeds 100%. Refinance risk deserves special attention for balloon loans: the borrower must qualify for a new loan at maturity under then current rates and cap rates. A loan that sizes comfortably today but fails a reasonable refinance test should be resized or structured with amortization or cash sweeps.

Sizing a commercial mortgage with four constraints

1. Property NOI is $1,500,000 and the underwritten value is $25,000,000, an implied 6.0% cap rate.
2. LTV constraint at 65%: $25,000,000 x 0.65 = $16,250,000.
3. Debt yield constraint at 9.0%: $1,500,000 / 0.09 = $16,666,667.
4. DSCR constraint at 1.25x: maximum debt service = $1,500,000 / 1.25 = $1,200,000. At 6.5% with 30-year monthly amortization, the annual mortgage constant is about 7.585%, so the maximum loan = $1,200,000 / 0.07585 = about $15,821,000.
5. The binding constraint is DSCR at about $15,821,000, which is 63.3% LTV ($15,821,000 / $25,000,000) and a 9.48% debt yield ($1,500,000 / $15,821,000). A drop in the rate or a longer amortization would shift the binding test to LTV.

How underwriters apply this

• Calculate every applicable constraint and lend the minimum; document which test binds and why.
• Size coverage on an amortizing payment even when the loan has an interest only period.
• Use debt yield as a rate and appraisal independent backstop when values look stretched.
• Cross check the appraisal with an internally underwritten cap rate and size off the lower value.
• Run a refinance test at maturity under higher rates and cap rates for any balloon loan.
• For operating companies, pair a leverage multiple with a coverage test and verify EBITDA quality.

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Educational content written by practitioners. Not investment, accounting, legal or tax advice.