How to Underwrite a Commercial Real Estate Deal: A Complete Guide

The offering memorandum is your roadmap. This document—prepared by the broker or seller's team—contains the property description, financial history, lease abstracts, tenant creditworthiness, market analysis, and photos. Carefully read through to understand:

• • Property location, asset class, size, and condition
• • Lease structure and tenant profile
• • Capital improvements and deferred maintenance
• • Broker's opinion of value and market outlook
• • Known risks and property assumptions

The rent roll lists every tenant, lease terms, and payment history. This is critical. Build a detailed analysis:

• → Tenant concentration: Is revenue too dependent on one or two tenants?
• → Lease expirations: When do leases roll? Will you have vacancy risk?
• → Rent growth: Are rents at market? Is there upside on renewal?
• → Collection history: Any late payments or problem tenants?

T12 refers to trailing twelve months of actual operating data. Request the last 3 years of P&Ls to spot trends. Analyze:

• → Actual rents received: Does it match the rent roll?
• → Operating expenses: Property taxes, insurance, maintenance, utilities, management fees
• → Trends: Are expenses growing? Are rents keeping pace?
• → Anomalies: One-time charges, capital replacements, unusual expenses

Use rent roll analysis and T12 data to project future rental income. Consider:

• → Base rent growth: Typically 2–4% annually, adjusted for market conditions
• → Tenant roll: When leases expire, assume realistic market rates (may be below or above current rents)
• → Vacancy assumptions: Conservative assumption of 3–7% depending on market and asset class
• → Other income: Tenant reimbursements, parking fees, amenity charges

Project operating expenses for your hold period, typically 5–10 years. Key line items:

• → Property taxes: Grow at 2–3% annually (or per local assessor history)
• → Insurance: 1–2% of NOI, growing annually
• → Maintenance/repairs: Typically 8–15% of NOI depending on age and condition
• → Utilities: If owner-paid, typically 5–10% of NOI
• → Staffing/management: Property management fees, leasing commissions

NOI is the foundation of all CRE valuation. The formula is simple but critical:

Project NOI for each year of your hold period. Year 1 NOI (after stabilization) is used to calculate initial cap rate and valuation.

Most CRE deals are financed with leverage (typically 60–80% LTV). Work with your lender to determine:

• → Loan amount and interest rate: Based on market conditions and property quality
• → Amortization period: Typically 25–30 years for income properties
• → Term and extension options: When does the loan mature?
• → Covenants and reserves: Debt service reserves, capital reserves, prepayment penalties

Calculate annual debt service (principal + interest) to determine cash flow available to equity investors.

A Discounted Cash Flow (DCF) model projects cash flows over your hold period and discounts them back to present value. This is your primary valuation tool:

• → Years 1–5 (or 1–10): Project NOI, debt service, and equity cash flow annually
• → Terminal value: Assume a cap rate in year 5/10 to estimate sale price
• → Discount rate (WACC): Typically 8–12% for CRE, reflecting cost of capital and risk
• → NPV calculation: Sum of discounted annual cash flows plus discounted terminal value

The DCF model is the gold standard for valuation because it accounts for timing and risk.

Your base-case underwrite assumes everything goes to plan. But reality is uncertain. Sensitivity analysis tests how your returns change if key assumptions shift:

• → Rent growth: +/- 1–2% annual growth
• → Exit cap rate: +/- 50–100 bps at time of sale
• → Expense inflation: +/- 1–2% annual growth
• → Interest rates: If refinancing, model higher rate scenarios

Build a sensitivity table showing IRR and equity multiple across ranges of assumptions. This reveals deal robustness and downside risk.

If you have co-investors or preferred equity, model the cash flow waterfall to show how distributions are split:

• → Preferred return: Often 6–8% annually to preferred equity holders
• → GP contribution clawback: Return of general partner capital before profit splits
• → Profit split: Typical 70% LP / 30% GP after preferred return
• → Promote: GP upside on outperformance above a hurdle rate

The waterfall clarifies investor returns and aligns interests with your capital partners.

Synthesize your findings into a concise investment memo that summarizes deal thesis, key metrics, risks, and recommendation. This document guides final investment committee sign-off.