Underwriting FAQ
How the numbers on a commercial deal actually work, with real figures rather than definitions. If you can answer these, you can read an offering memorandum critically instead of taking it at face value.
Underwriting a deal
How do you underwrite a net lease deal?
Start from the lease, not the offering memorandum. Establish the actual net operating income after every expense the landlord genuinely bears, confirm the remaining term and who guarantees it, then test what happens if the tenant leaves at expiry. The valuation follows from those three answers. A model built on the broker's NOI without reading the lease is a model of the marketing.
What is the most common mistake in commercial real estate underwriting?
Accepting the seller's net operating income. Management fees get left out, no reserve for replacements is taken, and vacancy is assumed at zero. The NOI a seller advertises and the NOI a lender will underwrite are often materially different, and the gap between them is usually the whole negotiation.
How do I calculate cash-on-cash return?
Divide the annual pre-tax cash flow after debt service by the cash you actually invested. On a $5,000,000 purchase with $1,750,000 down, NOI of $325,000 and debt service of $232,000, cash flow is $93,000 and cash-on-cash is 5.3 percent.
What is DSCR and why do lenders care about it?
Debt service coverage ratio is net operating income divided by annual debt service. It is the main constraint on most commercial loans, with lenders typically wanting 1.20x to 1.35x. A deal that fails coverage gets resized to a smaller loan no matter what the appraisal says, which is why coverage often decides the equity cheque rather than loan-to-value.
What does a pro forma actually tell you?
A pro forma tells you what the seller believes, which is useful information about the seller. Treat every assumption as a claim to be tested: market rent, renewal probability, expense growth and above all the exit cap rate, which usually carries most of the projected return.
Terms and concepts
What is the difference between IRR and equity multiple?
IRR accounts for the timing of cash flows and rewards getting money back sooner. Equity multiple simply asks how much came back in total. A short hold can post an excellent IRR while returning very little in absolute terms, so the two are best read together.
What does WALT mean?
Weighted average lease term is the average remaining lease term across tenants, weighted by each tenant's share of income. The weighting is the point: a centre can show a healthy simple average while its largest income contributor expires next year.
What is an occupier in commercial real estate?
The occupier is the business that uses the space, as distinct from the investor who owns it. The industry splits along this line, with occupier services representing businesses seeking space and investment sales representing owners and buyers of the asset.
What is cost segregation?
A cost segregation study reclassifies building components into shorter depreciation lives so deductions come sooner. It is a trade rather than free money: accelerating depreciation lowers basis faster, which increases recapture exposure on a later taxable sale. Whether it makes sense depends on the holding plan and the taxpayer.
These questions come up constantly in the deal teardowns, where the same analysis runs against real properties.
Read the teardowns →General information about how commercial real estate transactions work. Not tax advice, legal advice, or a recommendation about any specific property. Exchange and tax outcomes depend on facts specific to you and your entity. Confirm anything that matters with a qualified tax adviser and, for a 1031 exchange, engage a Qualified Intermediary before your sale closes.