Key Metrics for Commercial Real Estate Underwriting

Operating Expenses 

Commercial properties have recurring expenses related to owning and maintaining the building year- round. These operating expenses (OpEx) may include property taxes, insurance, and common area maintenance. Typically, the maintenance for office buildings consists of electricity, janitorial, management fees, and other regular maintenance costs.

Vacancy Allowance

Underwriting accounts for the cost of vacancy to forecast future cash flows from any given property. Vacancy rates vary depending on location, market conditions, and asset type.

To calculate the vacancy allowance, you can use this equation:

Annual Vacancy Allowance = Estimated Vacancy % x Building’s Rentable Square Feet x Full Service Rental Rate

Net Operating Income (NOI)

NOI is used to evaluate the profitability of a commercial real estate asset or to determine its value. NOI calculates the actual income a property will produce in a year minus operating expenses.

The NOI also factors in a vacancy allowance and bad debt expense. This gauges what a property’s income will look like under realistic occupancy rates.

Capitalization Rates

The Capitalization Rate (Cap Rate) is the annual percentage return of a commercial real estate asset based on the future income (forward annual NOI) that the investment will generate.

Cap Rate = Forward Annual NOI / Purchase Price

A low cap rate (3% to 6%) means the cost is relatively high. A higher cap rate (7% to 10%) indicates a comparatively more affordable deal.

Potential Property Value

The most important part of CRE underwriting is calculating the potential property value for a commercial real estate investment.

This calculation takes into account the forecasted annual NOI along with the desired cap rate to derive a final dollar value for the property. This value is considered to be the maximum an investor would be willing to pay for the property.

Property Value = Forward Annual NOI / Cap Rate

Debt Service Coverage Ratio

The Debt Service Coverage Ratio (DSCR) is the ratio of a property’s NOI to its annual mortgage.

DSCR = NOI / Annual Mortgage

This ratio is critical for determining loan amounts. A higher ratio means a lower risk of default, which can translate into larger loan deals.

Net Present Value

Net Present Value (NPV) is used to determine future cash flows of a CRE property by discounting the cash flows to their present value. To calculate NPV, the projected cash flow of the CRE investment is reduced by a discount rate.

NPV combines all future cash flows of a property and provides a value in today’s dollars. This helps determine whether the asset will generate revenue, and if that revenue will be of value after evaluating the time and risk it takes to generate it.

Internal Rate of Return

Internal Rate of Return (IRR) is used to estimate the profitability of a commercial property. If the IRR is higher than the chosen discount rate, this means the property will produce more money than the cost of investment. IRR provides insight into a CRE investment’s return over the entire holding period.

Cost on Return

Cost on Return represents the annual return of the investment as a whole, without accounting for the initial acquisition cost. This metric is used for the purchase of an existing, stable property.

Return on Cost = Annual NOI / Cost of the CRE Investment

Return on Investment

Return on Investment (ROI) measures cash flow that will return to the investor. This is how ROI is calculated:

ROI = [NOI – (Capital Expenses + Debt Service Payments)] / Equity Invested