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  • Writer's pictureCole Farrell

Underwrite Commercial Real Estate in 7 Steps

Updated: Mar 28

There is a major difference between residential and commercial real estate evaluation. Residential real estate is valued by comparable property sales. Put simply, a house is worth what a similar house has sold for nearby, give or take for differences. This also applies to rentals if the property is between 1-4 units. On the contrary, commercial property is valued based on property performance. Put simply, if the property makes more profit, it is worth more.

This difference is important because this allows us to focus on property financials instead of property aesthetics. Underwriting any commercial property follows the same path each time, however, in this case, we're going to be underwriting a multifamily apartment building.


Step One - Determine your business plan

  • The first step in underwriting is creating an initial business plan. This is done by first looking at the property as a whole and devising a plan for it. If the units are outdated, this includes renovations, increasing rent, and possibly separating or billing back utilities.


Step Two - Determine Net Revenue (Current and Proforma)

  • Determine gross income

-Sum of all rents collected

  • Subtract vacancy, concessions, plus bad debt

  • Determine net revenue = gross income - vacancy, concessions, bad debt.

Step Three - Determine Expenses (Current and Proforma)

  • Operating expenses

Utilities

Repair and maintenance

Snow and landscaping

Turnover

Admin costs

Reserve contributions

Etc.

  • Taxes

  • Insurance

  • Management fees (Property management and asset management)

Step Four - Determine Value

  • Subtract all expenses from net revenue = net operating income (NOI)

  • Determine local cap rate

  • Value = NOI / Cap Rate

One of the challenges with determining value is finding the sweet spot of paying what the asset is currently worth versus paying for potential. There is a hot topic depending on who you are talking with. In reality, it's a bit of both. It's better to lean towards the side of current worth, however in the current environment, there needs to be a little give. The trick is to understand the story and the business plan.


Step Five - Determine Debt

  • Determine annual debt service (loan amount, interest rate, amortization)


Step Six - Determine Cash flow (Current and Proforma)

  • Subtract debt service from NOI to determine annual cash flow

  • Calculate return metrics:

Cash on Cash % = Cash flow/ Cash invested

IRR = Use calculator (very difficult)

Equity Multiple = Total proceeds/ initial investment

DSCR = Cashflow / Debt Service


Step Seven - Is it a Good Deal?

  • Compare to your criteria

Will it hit the desired returns?

Are you being conservative or aggressive in underwriting?

How long will this take?

Will there be enough value to refinance or sell?

Does the business plan make sense?


These are the seven basic steps to underwriting a commercial property. You find in these steps there is a lot of room for estimating. Be wary. It's better to be conservative and have more than enough than to be aggressive and not have enough.







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