The short answer
To underwrite a commercial real estate deal, rebuild the income from the rent roll, deduct vacancy, credit loss and the real operating expenses to reach net operating income (NOI), and divide NOI by a market cap rate to estimate value. Then add the financing, test whether the income covers the debt, measure the returns and stress every assumption behind them.
The point of commercial real estate underwriting is to reach your own number before you sign a letter of intent, so your offer comes from the property's economics, not the offering memorandum.
The core metrics and formulas
Every underwriting model, from a one-page pre-LOI analysis to a full CRE underwriting model, is built from the same handful of measures.
| Metric | Formula | What it tells you |
|---|---|---|
| Effective gross income (EGI) | Gross potential rent + other income − vacancy and credit loss | What the property can collect |
| Net operating income (NOI) | EGI − operating expenses | Earnings before financing |
| Cap rate | NOI ÷ price or value | One-year yield on the price, before debt |
| Loan-to-value (LTV) | Loan ÷ value | Share of the value borrowed |
| Debt service coverage ratio (DSCR) | NOI ÷ annual debt service | How many times income covers the loan payments |
| Debt yield | NOI ÷ loan | Income earned on the loan, whatever the rate |
| Cash-on-cash return | Annual cash flow after debt service ÷ equity invested | Yearly cash yield on your own money |
| Break-even occupancy | (Operating expenses + debt service) ÷ gross potential income | Occupancy below which cash flow turns negative |
| IRR | The rate that sets the present value of all equity cash flows to zero | Annual return over the whole hold, sale included |
Step 1: income, vacancy and credit loss
Income starts with the rent roll: every tenant or unit with its area, rent, lease dates, increases and options. Gross potential rent is the rent in place on leased space plus a realistic market rent on vacant space.
- Check it against the leases. Rents, expiries and free-rent periods should match the signed leases, and collected rent should match the bank deposits and the trailing twelve months of results, the T-12.
- Mark rents to market. Rents above market are at risk at expiry; rents below market are upside only when the leases let you reach them.
- Map the rollover. A fully leased building can face a wave of expiries in year two, with downtime and leasing costs attached.
Count other income, such as parking and reimbursed expenses, only as far as the leases support. Then deduct vacancy and credit loss, using the higher of the market's vacancy and the building's own record, and keep an allowance even when the building is full: leases end and tenants fail.
Step 2: operating expenses and NOI
The NOI calculation is effective gross income minus operating expenses, the costs of running the property: taxes, insurance, utilities, repairs, payroll, administration and management. NOI leaves out debt service, depreciation and income taxes; it measures the property, not the owner.
- Start from actuals. Use the T-12, not the seller's budget, and adjust for what changes under new ownership.
- Reprice taxes and insurance. In many places a sale triggers a new tax assessment near the purchase price, and insurance belongs on a current quote.
- Charge a management fee even if you self-manage. The next buyer, and the lender, will.
- Pick one convention for reserves. Lenders typically deduct a reserve for replacements before NOI; many sellers do not.
Compare each line per square foot or per unit with similar buildings: an expense far below its peers is usually a missing cost, not a well-run building.
Step 3: value and financing
Value equals NOI divided by the cap rate, using a rate drawn from recent comparable sales and NOI you have rebuilt yourself. Small changes in that rate move value a long way, as our guide to cap rates and how to stress test them shows.
Lenders typically size a loan with three tests and lend the smallest amount any of them allows: loan-to-value (LTV), the loan as a share of value; the debt service coverage ratio (DSCR), NOI divided by the annual loan payments; and debt yield, NOI divided by the loan, which ignores the interest rate and amortization altogether.
The interest rate and the amortization period set the annual debt service. A longer amortization lowers the payment; interest-only periods lower it further but repay nothing. Compare the loan constant, annual debt service divided by the loan, with the cap rate: when the payments cost more than the property yields, borrowing lowers your cash return.
Step 4: returns
- Cash-on-cash return is the year's cash flow after debt service divided by your equity. It shows what the property pays while you hold it, but ignores the sale and the timing of money.
- IRR, the internal rate of return, is the annual rate at which the present value of every equity cash flow, from purchase to sale, comes to zero. It captures the whole hold, so it is sensitive to the exit cap rate and the hold period.
Run the returns without debt first: a property that only works with leverage is a financing bet. And if most of the IRR comes from the sale, the deal is a bet on the exit cap rate.
A worked example (hypothetical)
An invented building, with rounded figures, shows how the metrics connect.
| Line | Figure | Working |
|---|---|---|
| Gross potential rent | $1,000,000 | From the rent roll |
| Vacancy and credit loss | −$100,000 | 10% of gross potential rent |
| Effective gross income | $900,000 | $1,000,000 − $100,000 |
| Operating expenses, with reserves | −$300,000 | From the T-12, adjusted |
| NOI | $600,000 | $900,000 − $300,000 |
| Price and going-in cap rate | $10,000,000 at 6.0% | $600,000 ÷ $10,000,000 |
| Loan at 60% LTV | $6,000,000 | 60% × $10,000,000 |
| Annual debt service | About $431,700 | 6.0% interest, 30-year amortization, monthly payments |
| DSCR | 1.39 | $600,000 ÷ $431,700 |
| Debt yield | 10.0% | $600,000 ÷ $6,000,000 |
| Cash flow after debt service | About $168,300 | $600,000 − $431,700 |
| Cash-on-cash return | 4.2% | $168,300 ÷ $4,000,000 of equity, before closing costs |
| Break-even occupancy | 73.2% | ($300,000 + $431,700) ÷ $1,000,000 |
The income covers the debt comfortably, but the loan constant, $431,700 ÷ $6,000,000 or about 7.2%, is above the 6.0% the property yields. Borrowing therefore lowers the cash return from 6.0% to 4.2%, although part of each payment is principal that builds equity.
Sensitivity and stress tests
What matters is not the base case but which assumption moves the answer most, and how much can go wrong before the deal fails.
- Sensitivity. Move rent, vacancy, expenses, interest rate and exit cap rate one at a time, by amounts the market has actually seen, and rank their effect.
- Stress. Move them together, the way they tend to move in a real downturn.
- Break-even points. Find the occupancy, interest rate and exit cap rate at which cash flow, debt coverage or your equity runs out.
In the example, raising vacancy from 10% to 15% cuts NOI to $550,000, DSCR to 1.27 and cash-on-cash to 3.0%. Selling on the same $600,000 NOI at a 6.5% cap rate instead of 6.0% values the building at about $9.23 million, 7.7% below the price paid. And below 73.2% occupancy, the income no longer covers expenses and the loan.
Read the offering memorandum skeptically, and know when to walk away
An offering memorandum (OM) is written to sell the property: use it for facts about the building and leases, and rebuild the rest. Watch for:
- Pro forma in place of actuals: projected NOI, with rents raised and vacancy cut, presented as today's income.
- Rents the building has never achieved, with no recent leases behind them.
- Missing expenses: no management fee, no reserves, taxes at the old assessment.
- Hidden rollover: large leases expiring early in the hold, free rent and weak tenant credit.
Walk away when the deal only works on the pro forma, when coverage breaks the lender's minimum in a plausible downside, when break-even occupancy sits close to what the market achieves, when the return needs a lower cap rate at sale than at purchase, or when the rent roll, leases, T-12 and bank statements cannot be reconciled.
How REALIST does it
REALIST: pre-LOI clarity in the time it takes to read the OM
Open the property file in REALIST and the underwriting model is already loaded, with per-floor rent assumptions, conservative operating expenses and a neighborhood benchmark cap rate. You read the offering memorandum with the verdict score already on screen, and no spreadsheet to build first.
Every assumption (income, expenses, financing and exit) is a visible, editable input, and moving a slider updates the return picture in the same frame. The cap-rate sweep, financing stress and vacancy stress show which assumption matters most, and the verdict score places the asset as supported, stretched or aggressive given the inputs on screen. The decision stays with you.
For acquisition and origination pipelines, REALIST API returns NOI, cap rate, financing stress and a verdict score for any property, so every deal carries numbers the moment it enters the pipeline.
Questions
What does it mean to underwrite a commercial real estate deal?
Working out, independently of the seller, what a property earns, what it is worth, how much debt it can carry and what it returns, then testing those answers against a downside. The result sets the price you offer.
How do you calculate NOI?
Take gross potential rent plus other income, subtract vacancy and credit loss to reach effective gross income, then subtract operating expenses. NOI excludes debt service, depreciation and income taxes.
What is a good DSCR for a commercial loan?
Lenders set their own minimums by property type and loan program, commonly around 1.25 for stabilized property. The higher the ratio, the further income can fall before the loan payments are at risk.
What is pre-LOI analysis?
The underwriting done before you submit a letter of intent. It sets your price, so later due diligence confirms the numbers rather than discovering them.
What is the difference between cash-on-cash return and IRR?
Cash-on-cash return is one year's cash flow after debt service divided by the equity invested. IRR is the annual return over the whole hold, including the sale and the timing of every cash flow.
