Real Estate Underwriting Explained

If you’ve ever wondered how commercial real estate investors decide on an offer price for a property, the underwriting process is the key to making that happen.

And unlike single-family home sales, where the price per square foot of similar properties in the area will typically have the biggest influence on pricing, coming up with a value for a commercial property involves a lot more moving pieces.

So in this post, we’ll break down the underwriting process that commercial real estate investors use when evaluating new acquisition and development opportunities, and some of the most important things to think about when analyzing a deal.

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Step #1: Build (or Download) a Financial Model

The first thing you’ll need to get started with the real estate underwriting process is a financial model you can use to create projected cash flows.

This model also needs to be dynamic, meaning that the cash flow projections you create in this pro forma will automatically update as assumptions in the model are changed.

And regardless of whether you build your own model or start with one of the pre-built templates we have inside Break Into CRE Academy, the goal is to have a clear, straightforward model you can use to analyze different scenarios quickly (in a format you understand).

Step #2: Add Basic Property Information

Once you have your model up and running, the next part of the underwriting process is adding some basic information about the deal that would be important to know when analyzing the investment.

This typically includes things like the location of the property, the year the property was built, and the number of units or the total square footage of the building, and can usually be found directly within an offering memorandum put together by the broker.

Step #3: Add In-Place Revenue and Expenses

From here, you’ll start to add some inputs that will impact the cash flows you can expect to generate as an investor, starting with the property’s in-place revenue and expenses.

This information can typically be found in a current rent roll (which lists the key lease information for each commercial suite or multifamily unit at a property), and the property’s T-12 financial statements will show the trailing 12 months of actual revenue and expenses for the seller.

From a rent roll perspective, the biggest things to look for here will be the base rent owed by each tenant, along with any scheduled rent increases over time. You’ll also want to incorporate any other charges associated with each lease, like monthly parking fees, monthly storage fees, or any operating expense reimbursement structures that the tenant might be subject to.

And from an operating expense perspective, you’ll want to get a sense of what ordinary operating expenses have looked like in the past, and you’ll also want to identify any major fluctuations or outliers in those financials that could be a sign of other issues going on.

Step #4: Add Operating Assumptions

Once the property’s in-place operating information is added to your model, the next step in the underwriting process is incorporating your own operating assumptions for the property going forward.

These operating assumptions typically fall into three main categories, which are operating cash flow assumptions, capital cost assumptions, and re-leasing assumptions for in-place tenants.

For operating cash flow assumptions, these include things like assumed market rent growth over time, assumed operating expense growth over time, and assumed vacancy levels at the property each year, which usually require some research using industry databases or market reports.

For capital cost assumptions, these include both the timing and amounts of projected construction costs on the investment, and these almost always require the input of an experienced general contractor.

And for commercial (retail, office, and industrial) properties, leasing assumptions when in-place leases expire (or vacant spaces are expected to be leased up) can also have a big impact on the projected performance of a deal. These will often require the input of an experienced leasing agent in the market, to provide guidance on things like expected downtime between leases, current market rents for each suite, and any TI allowances or brokerage commissions you can expect to pay when a new lease is signed.

Step #5: Add Debt Assumptions

Once your operating assumptions are added to the model, the next step in the underwriting process is adding your projected debt financing assumptions.

This includes adding things like the projected loan amount, loan term, amortization period, interest rate, and potentially even an interest-only period on the loan, and this could also include refinance projections if the initial loan term is shorter than the projected hold period.

All of this information will usually come directly from a lender or mortgage broker, and while you typically won’t be able to get concrete loan terms you can rely on before a property is under contract, this will at least get you in the ballpark when making your projections.

Step #6: Add Sale Assumptions

Once you have your loan information in the model, the next step of the underwriting process is to add your sale assumptions on the deal, including both how much you plan to sell the property for and when you plan to exit the investment.

In the vast majority of acquisition and development models, sale values are calculated based on what’s referred to as an exit cap rate assumption. This takes the next buyer’s projected first year of net operating income and divides that by what the investor believes cap rates will be in the market at the time the property is sold.

Investors will typically underwrite cap rate movement based on where they believe both interest rates and investor demand for commercial real estate will trend over time. And because this can have such a huge impact on the projected returns of an investment, this can be one of the hardest (and one of the highest-stakes) assumptions to make during the underwriting process.

If interest rates are expected to rise and demand for real estate is expected to fall, investors will typically underwrite cap rates increasing over the going-in cap rate on the deal, and if interest rates are expected to fall and demand for real estate is expected to rise, investors will typically underwrite cap rates to either stay the same (to be conservative) or decrease slightly during the projected hold period.

Costs of sale can also have a material impact on overall investment performance, with brokerage commissions, closing costs, and transfer taxes often eating up anywhere from roughly 2%-5% of the gross sale proceeds on a deal, so this is also something that needs to be incorporated into a real estate financial model.

Step #7: Calculate Value Using Target Returns

Finally, once we have all of this information in our pro forma, the last step of this process is to come up with a valuation of the deal based on target returns.

In most cases, equity investors are investing in real estate in the first place to generate an IRR, equity multiple, and/or cash-on-cash return, and the projected offer price on a transaction will need to be adjusted based on those requirements.

This means that if an investor is targeting a 12% IRR over a 5-year hold period and the asking price on the deal is $10 million, if that $10 million purchase price only produces a 9% IRR in the investor’s underwriting model, that offer price would end up being reduced until that 12% IRR target is hit.

How To Learn More About Real Estate Underwriting & Analysis

If you want to learn more about how to use a pre-built pro forma model to analyze real estate acquisition and development opportunities, or you want to learn how to build your own real estate underwriting models from scratch in Excel, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.