Scope’s innovative CRE rating methodology embeds all three metrics as the cornerstone of its credit risk framework: DSCR for term default risk analysis; DY and LTV for refinancing risk analysis

Debt yield (DY) is a gearing ratio measuring property cashflows as a percentage of outstanding debt. “As a dynamic operating performance metric, it is particularly appropriate for measuring refinancing risk and conducting peer analysis with limited risks to be manipulated,” said Florent Albert, a director in the structure finance team of Scope Ratings.

Debt yield, Loan-to-Value and Debt Service Coverage Ratio are complementary because they measure different aspects of credit risk. DY focuses on levered returns, LTV addresses debt leverage, while DSCR captures debt servicing capacity.

DY is superior to LTV for measuring refinancing risk in an environment of rising interest rates or in a rebasing environment as it provides a forward-looking break-even measure on a debt refinancing rate. LTV, by contrast, is essentially a lagged measure of over-collateralisation. DSCR remains the primary measure of borrower payment capacity i.e. term default risk.

“DY has several advantages. It is a dynamic forward-looking measure of refinancing risk that is hard to manipulate. It has peer analysis benefits and is a pure cashflow metric capturing idiosyncratic risks only,” said Albert, while acknowledging its limitations: it does not directly assess current debt-servicing capacity and is not as intuitive as DSCR to determine debt-servicing risk. Nor is it as intuitive as LTV to assess recoveries given default and it can be volatile because of its cashflow-intrinsic component calculated over a short-term horizon.

“A benefit of the DY formula is it is sensitive to a transaction’s cashflows only, while LTV and DSCR are directly impacted by exogenous macro factors i.e. capitalisation rate or reference rates,” Albert explained. “Furthermore, the formula is not subject to subjectivity or manipulation, as may be the case for LTV and DSCR. This makes DY particularly suitable for peer analysis.”

CRE lenders should consider DY, LTV and DSCR together to fully understand the credit risks they face:

• DY to size refinancing risks in a potential rising interest-rate environment or on a rebasing risk environment triggering more expensive debt like in a Covid-19 environment;
• DSCR to determine a borrower’s debt-servicing capacity disregarding property valuation if net operating income shrinks, as is currently the case in the UK high street retail sector
• LTV to determine the appropriate debt leverage level excluding cashflow considerations like for asset classes suffering during the Covid-19 lockdown period (hospitality, student housing).

Scope expected-loss CRE methodology assumes a default to occur in the following scenarios:

• Term default: as soon as our projected DSCR is lower than one.
• Refinancing default if our projected CRE portfolio’s exit debt yield is lower than Scope’s estimated all-in refinancing rate or if our projected loan-to-value equals or is above 100%.

Download the full report here.