Underwriting CRE Deals

CRE underwriting is forensic accounting meets crystal-ball gazing. You gather 12 months of actual operating data (T12), analyze individual tenant leases (rent roll), benchmark against comparable properties (comps), stress test key assumptions (occupancy, rents, expenses), and build a forecast model. A small error in occupancy or expense growth can swing the deal by millions.

Key takeaways

• T12 (Trailing Twelve Months): The last 12 months of actual income and expense data, the foundation of every underwriting model.
• Rent roll: Spreadsheet of every tenant, lease rate, lease expiry, renewal options, credit quality—critical for forecasting rent growth and renewal risk.
• Market comps: Comparable recent sales/leases of similar properties, used to validate your cap-rate assumptions and rental rates.
• Stress testing: Model occupancy, rent, and expense scenarios (pessimistic, base, optimistic) to understand deal sensitivity.
• DSCR and LTV: Key lending tests; most deals require DSCR ≥ 1.2x and LTV ≤ 65%.
• Ownership structures: Hold the underwriting constant but vary capital structure (debt/equity mix, preferred equity) to optimize returns.

The T12: Your ground truth

Before any model, you need the T12—the trailing twelve months of operating statement. This is the actual, audited (or at least reviewed) income and expense for the past year.

A typical multifamily T12:

TRAILING TWELVE MONTHS (TTM): Month 1 - Month 12

INCOME:
  Rent (100 units × avg $2,000/month, ~88% occupancy)      $2,112,000
  Vacancy loss (12% @ $2,400 potential)                        ($288,000)
  Effective rental income                                    $1,824,000
  Parking, storage, laundry                                     $48,000
  Total GROSS OPERATING INCOME                              $1,872,000

EXPENSES:
  Payroll (resident manager, maintenance)                    $240,000
  Repairs & maintenance                                      $180,000
  Utilities (electricity, gas, water)                        $120,000
  Property tax                                               $480,000
  Insurance                                                  $120,000
  Landscaping & grounds                                       $36,000
  Office & supplies                                           $24,000
  Advertising & leasing                                       $48,000
  Legal & professional                                        $24,000
  HOA (if applicable)                                             $0
  Total OPERATING EXPENSES                                   $1,272,000

NET OPERATING INCOME (NOI)                                   $600,000

Cap rate at purchase price of $12.5M: 4.8%

This $600,000 NOI is your starting point for every underwriting model. Lenders will normalize it (adjust for one-time items, owner perks that won't recur), but the T12 is the baseline.

Critical: Verify the T12. Did the seller provide reconciled bank statements? Rental receipts? Or just a PDF that may understate expenses? Experienced underwriters always request:

• Bank statements for 12 months (to verify rent deposits)
• Utility bills (to verify expense claims)
• Property tax assessments (to verify property tax)
• Payroll records (to verify staffing costs)
• Insurance declarations (to verify coverage and cost)

A T12 showing $600k NOI is worth $12.5M at a 4.8% cap rate. A revised T12 showing $550k NOI (if expenses were understated) is worth $11.5M. The $1M difference matters.

The rent roll: Your lease-by-lease view

The rent roll is a spreadsheet listing every tenant, their lease terms, rates, and expirations. It looks like:

Unit	Tenant	Move-In	Lease Expiry	Annual Rent	Renewal Option	Status
101	Smith	2021-03	2026-02	$24,000	2-year	Good
102	Vacant	--	--	--	--	Lease-up
103	Jones	2019-08	2024-12	$21,600	None	Expiring
104	Brown	2022-01	2027-01	$25,200	2-year	Good
105	Davis	2023-06	2026-06	$26,400	None	At-risk

From this rent roll, you extract:

1. Occupancy: 4 occupied, 1 vacant = 80% occupancy (given 5 units, $97,200 annual rent vs. $120,000 potential = 81% effective occupancy)

2. Rent growth needs: Unit 103 expires end of 2024. Current rent $1,800/month. Market rent $2,000/month. Upside if renewed.

3. Renewal risk: Units 103 and 105 have no renewal options or expiring options. If tenants leave, what's the cost to re-lease (vacancy, leasing commissions)?

4. Tenant quality: All tenants paying on time = good credit. If one tenant is behind, note it.

5. Lease term concentration: Are all leases expiring in 2025? That's refinance risk (DSCR test is based on post-renewal income, which is uncertain).

For multifamily, the rent roll is less critical (month-to-month leases are norm). For office, retail, or industrial—with multi-year leases—the rent roll is essential. A net-lease warehouse leased to Costco through 2030 at $1.50/sf is very different from a property with tenants expiring every 6 months.

Market comps: Validating your assumptions

You estimate the property will rent at $2,100/month per unit after renovations. Is that realistic? Check market comps.

Market comps are recent sales (or long-term leases) of similar properties in the same market. You look for:

• Same asset class (apartments, office, retail, industrial)
• Same sub-market (not the whole city, but the specific zip code or corridor)
• Recent transactions (within 6–12 months)
• Similar quality (Class A comparable to Class A, not Class A vs. Class C)

Example: Your apartment property is in Austin, North Austin submarket, 100 units, Class B. Recent comps in the market:

Property	Units	Sale Price	Price/Unit	Implied Cap Rate
Onyx Apartments	120	$45M	$375k	4.4%
Laurel Park	95	$32M	$337k	4.8%
Rio Grande Lofts	110	$38M	$345k	4.6%
Avg. Comps	--	--	$352k	4.6%
Your property (assumed)	100	$35M	$350k	4.7%

If market comps are trading at $350k/unit, your underwriting at $350k/unit is reasonable. If comps are at $400k/unit and you're assuming $350k, you're conservative (good). If comps are at $300k/unit and you're assuming $350k, you're aggressive (risky).

Comps also validate rental rates. If recent lease comparables in your market show new leases at $2,100/month, your underwriting of $2,100 is grounded. If comps are $1,950, your $2,100 is optimistic.

Building the underwriting model

A CRE underwriting model typically projects 10 years of operations:

Year 1 (Stabilization):

• Occupancy: 90% (gradual ramp from acquisition occupancy)

• Rent per unit: $2,050/month (average)

• Gross rental income: 100 units × $2,050 × 12 × 90% = $2,214,000

• Vacancy & concessions: -$50,000

• Other income (parking, laundry): $50,000

• Effective rental income: $2,214,000

• Operating expenses: $1,100,000 (14% of gross income, or normalized from T12)

• NOI: $1,114,000

• Cap rate: 4.5% ($1,114,000 / $24.75M purchase price)

Year 2–5:

• Rent growth: 2.5%/year (below inflation, reflects conservative forecast)
• Occupancy: 94% (stabilized)
• Expense growth: 3%/year (inflation)
• NOI grows as rents > expenses

Year 6–10:

• Rent growth: 2%/year
• Occupancy: 94%
• Expense growth: 3%/year
• Property matures

Exit (Year 5 or 10):

• Sell at assumed cap rate (e.g., 4.2%)
• Proceeds minus debt payoff = equity profit

Scenario analysis: Base, bull, bear

Smart underwriting includes three scenarios:

Bear case: Conservative assumptions, downside protection

• Occupancy: 85%
• Rent growth: 1%
• Expense growth: 4% (inflation)
• Exit cap rate: 5.0% (cap rate expansion)
• NOI in Year 5: $950,000 (vs. base case $1,200,000)

Base case: Reasonable assumptions based on underwriting

• Occupancy: 92%
• Rent growth: 2.5%
• Expense growth: 3%
• Exit cap rate: 4.5%
• NOI in Year 5: $1,200,000

Bull case: Optimistic, upside scenario

• Occupancy: 95%
• Rent growth: 4% (above inflation, market strength)
• Expense growth: 2%
• Exit cap rate: 4.0% (cap rate compression)
• NOI in Year 5: $1,400,000

From these, you calculate equity IRR:

Scenario	Year 5 Exit Value	Debt Payoff	Equity Profit	IRR (5yr hold)
Bear	$19.0M	$18.5M	$0.5M	2%
Base	$26.7M	$18.0M	$8.7M	15%
Bull	$35.0M	$17.5M	$17.5M	28%

If the bear case IRR is 2% and base case is 15%, the deal is risky but potentially worthwhile (if you believe base case is likely). If bear case is negative IRR, the deal is broken—you lose money even if occupancy drops 5%.

Key underwriting metrics

DSCR (Debt Service Coverage Ratio):

• Formula: NOI / Annual Debt Service
• Lenders want: ≥ 1.2x (ideally 1.25–1.3x)
• Example: NOI $600k, annual debt service $480k (on $12M loan) = DSCR 1.25x ✓

LTV (Loan-to-Value):

• Formula: Loan Amount / Property Value (appraised)
• Lenders want: ≤ 65% (sometimes 70% for strong sponsors)
• Example: $15M loan on $25M property = 60% LTV ✓

Debt yield:

• Formula: NOI / Loan Amount
• CMBS lenders require: ≥ 7–8%
• Example: $600k NOI / $12M loan = 5% debt yield (fails CMBS test; needs different loan structure)

Return on equity (ROE):

• Formula: Equity cash flow (after debt service) / Equity invested
• Year 1 ROE: ($600k NOI - $480k debt service) / $5M equity = 2.4% (low; suggests leverage is tight)

Sensitivity analysis: What breaks the deal?

Identify the key sensitivities. In most multifamily deals:

1. Occupancy: What occupancy breaks DSCR 1.2x?

   • If NOI is $600k at 90% occupancy and debt service is $480k, dropping to 85% occupancy might reduce NOI to $550k, dropping DSCR to 1.15x (failure).

2. Rent growth: How much do rents need to grow to hit your return targets?

   • If your 5-year IRR assumes 2.5% rent growth but market is only 1%, does the deal still work?

3. Exit cap rate: How much can cap rates expand before you lose money?

   • If you exit at 5% cap rate (vs. 4.5% assumed), property value drops $X, equity profit drops by $X.

4. Interest rates / refinance: How much can rates spike before your Year 3 refinance fails?

   • If you're planning to refinance at Year 3 at 5% but rates spike to 7%, you're stuck in bridge debt at 9%+.

A professional underwriting includes tornado charts showing these sensitivities:

SENSITIVITY ANALYSIS (5-Year IRR)

Occupancy:
  85% → 12% IRR (baseline 15%)
  90% → 15%
  95% → 17%

Rent growth:
  1.0% → 10%
  2.5% → 15%
  4.0% → 20%

Exit cap rate:
  4.0% → 18%
  4.5% → 15%
  5.0% → 12%

If the deal is sensitive to occupancy (small movement breaks DSCR), it's risky. If the deal is insensitive (occupancy can drop 10% and still hit 12% IRR), it's safer.

Common underwriting pitfalls

1. Overstating rent growth: Market comps show 2% rent growth; model assumes 3%. This alone can swing a deal by $500k of NOI.

2. Understating expenses: Seller's T12 shows $1M expenses; lender underwriting normalizes to $1.2M (including long-term capex, tenant turnover, etc.). Always normalize upward from T12.

3. Ignoring lease expirations: Model assumes 95% occupancy, but 40% of rents expire in Year 1. If renewal rate is only 80%, occupancy drops and NOI swings.

4. Overstating capex efficiency: Model assumes $2/sf capex for renovations; actual contractor bids are $3/sf. Value-add play breaks.

5. Underestimating refinance risk: Model assumes refinance at 5% in Year 3; if rates are 7%, refinance fails. Stress test refinance scenarios.

The underwriting checklist

Before modeling, gather:

• 24 months of P&L statements (at least T12)
• Rent roll with tenant names, lease dates, expirations
• Property tax bill
• Insurance declarations
• Utility bills
• Capital improvement/maintenance records
• Recent appraisal (or order new one)
• Market comps (recent sales, leases)
• Market report (local supply/demand, rent trends)
• Lender requirements (DSCR, LTV, recourse tests)

The underwriting flow

Related concepts

• Cap rates and their role in valuation
• CRE financing and its effect on returns
• Bridge loans and value-add financing

Next

Underwriting is the backbone of individual deal analysis. But individual deals are often owned not directly by sponsors, but through funds, partnerships, and syndicates. The next article covers CRE syndication: how passive investors can get exposure to professional-grade CRE deals without buying and managing a property themselves. This is the vehicle through which most retail investors access CRE beyond REITs.