Answers
Underwriting, explained
The questions that come up on every deal, answered properly. No gated downloads and no sign-up. Each page opens with the whole answer and then shows the work.
- What is a T-12 in real estate?A T-12 is a trailing twelve month operating statement: every income and expense line a property actually produced over the last twelve months, almost always presented as twelve monthly columns with an annual total. Buyers ask for it because it is the one document in a deal package that reports what happened rather than what the seller projects. Underwriting starts by normalizing it, which means restating the seller's expenses at what they will cost under your ownership.
- How do you read a rent roll?A rent roll is a snapshot of what is leased right now: unit by unit for residential, tenant by tenant for commercial, showing who occupies the space, at what rent, and until when. Read it for three things. What is actually being collected today, how far that sits from market, and when each lease rolls.
- How do you calculate net operating income (NOI)?Net operating income is effective gross income minus operating expenses. Effective gross income is gross potential rent less vacancy, concessions and credit loss, plus other income. The arithmetic is trivial; the difficulty is deciding which lines count as operating expenses, because debt service, capital expenditure, tenant improvements, leasing commissions, depreciation and income taxes are all excluded by definition.
- How do lenders size a commercial real estate loan?A lender runs three independent tests and lends the smallest result. A loan-to-value cap limits the loan to a percentage of appraised value. A minimum debt service coverage ratio limits it to the debt the property's net operating income can service, usually tested at a stressed rate. A debt yield floor limits it to net operating income divided by a required yield. Which of the three binds tells you more about the market than any single ratio does.
- Cap rate, cash-on-cash, or IRR: which return metric should you use?They answer three different questions, so the choice is not between them. A cap rate prices the asset unlevered at a single moment: net operating income divided by value. Cash-on-cash measures one year of levered cash flow against the equity invested. Internal rate of return measures the entire hold including the sale, weighted by when each dollar arrives. Read together with the equity multiple they describe a deal; read alone, each one is easy to game.
- What is a good cap rate?There is no single good cap rate, because a cap rate is a price, not a grade: it is what a buyer pays today for a dollar of a property's net operating income. Whether a given rate is attractive depends on what risk-free alternatives yield, how much the income can grow, and how likely the income is to arrive, which is why stabilized assets with durable income trade at lower cap rates than older assets with shakier income. The useful questions are relative ones: how the rate compares to the ten-year Treasury yield, to the cost of the debt, and to closed trades on comparable properties with the NOI rebuilt on your own conventions.
- What is a good DSCR?Most commercial real estate lenders set minimum debt service coverage ratios in the 1.20x to 1.25x range, so a DSCR at or above 1.25x clears the common covenant, and ratios around 1.40x and higher read as conservative. Riskier asset classes and riskier business plans carry higher floors, and the minimum that governs your deal is the one on your term sheet, tested the lender's way: usually at a stressed rate, on an amortizing payment, against the lender's own normalized NOI. The more useful reading is the cushion: a 1.25x DSCR means income can fall 20% before it stops covering the payment.
- What is a good cash-on-cash return?There is no universal good cash-on-cash return, because the number is as much a statement about the financing and the rate environment as about the property: the same building shows a different cash-on-cash at every loan size, coupon and amortization, with nothing about its operations changed. The honest benchmark is the loan constant. When the cap rate sits above the constant, leverage is positive and borrowing raises the cash return; when it sits below, every borrowed dollar lowers it, and a thin year-one figure is what honest arithmetic produces. It is also a pre-tax, single-year measure that ignores principal paydown, appreciation and the sale, so it says whether a deal pays you during the hold, not whether it performs overall.
- What is a good IRR for real estate?There is no single good IRR, because the number is set as much by four decisions as by the property: how much leverage the deal carries, how long it is held, how much risk the strategy takes, and whether the figure is quoted before or after fees and promote. A levered IRR and an unlevered IRR on the identical building are not comparable, and neither are two levered IRRs at different hold periods. The productive test is relational: read every internal rate of return next to its equity multiple, its hold period, its leverage, and the exit cap rate that produced it, because on a typical five-year hold the exit assumption is carrying most of the number.
- How do you calculate IRR in real estate?Build the cash flow series first, then solve for the rate that makes its present value zero. Lay out the equity going in at close as a negative figure, each year's cash flow after debt service, and the net sale proceeds in the final year, and find the discount rate at which all of those, discounted back, sum to nothing. There is no formula to rearrange: every tool reaches the answer by trial, which is why getting the series right matters far more than the method used to solve it.
- What is the difference between IRR and equity multiple?The difference is time. The equity multiple is every dollar returned divided by every dollar invested, so it measures how much you made and says nothing about when. The internal rate of return is the annual compounding rate that would have produced the same series, so it measures how hard the money worked and rises when the same profit arrives sooner. Neither is complete on its own, which is why they are always quoted together, with the hold period beside them.
- What is a good debt yield?There is no market wide number, and any page that gives you one is quoting a convention rather than an offer. Floors in the region of 9 to 10 percent are commonly discussed for stabilized commercial property, with the bar higher for hospitality, single tenant and transitional assets where the income is lumpier or less proven, and lower where it is long dated and investment grade. What makes a debt yield good on your deal is whether it clears the floor on your term sheet with room left over, and how much room.
- Interest only or amortizing: which is better on a commercial loan?Interest only lowers the payment while it lasts and raises what the loan costs in total. Nothing is repaid during it, so the balance stays where it started, every month of interest afterwards is charged on that larger balance, and more falls due at maturity. It is worth taking when the business plan genuinely needs the cash in those specific years and you have a credible answer for the bigger balloon. It is expensive when it is taken to make a deal pencil that otherwise would not.
- How does a real estate distribution waterfall work?A distribution waterfall is the order in which cash from a property is split between the limited partners who funded it and the general partner who runs it. The common sequence pays a preferred return on limited partner capital first, then returns that capital, then splits whatever remains on terms that favor the general partner. That disproportionate share of the remainder is the promote, and it is the sponsor's actual compensation for performance.
- How do you model lease rollover, TI and LC in office and retail?Model each tenant on its own expiration, not on a portfolio average. At every roll date decide the market rent, a renewal probability, and the capital each outcome requires: renewal terms with a lower tenant improvement allowance and a shorter downtime, or a new lease with a higher allowance, a full leasing commission, and months of vacancy before rent restarts. The blended result of those two outcomes is the cash flow. The capital is usually what decides the deal.
- How should you read an offering memorandum?An offering memorandum is the seller's marketing document. It is usually the best available summary of the asset and the least reliable set of forward numbers in the package, because the pro forma inside it is an argument rather than an underwriting. Read the exhibits first, build your own year one from the rent roll and the T-12, and treat the narrative as a source of questions rather than answers.
- What documents do you need to underwrite a real estate deal?Four documents carry almost all of it: the rent roll, the trailing twelve month operating statement, the offering memorandum, and a debt quote or term sheet. The rent roll says what is leased and until when, the T-12 says what the property actually earned and spent, the memorandum supplies the story and the exhibits, and the quote fixes the loan that the returns depend on. Everything else, from the tax bill to the insurance loss run to the property condition report, exists to confirm or contradict a line one of those four already raised.
- How long does it take to underwrite a deal?It depends almost entirely on how much of the work is re-keying rather than thinking. A first-pass screen on a clean multifamily package is an afternoon for somebody experienced. A full institutional underwriting with a lease-by-lease commercial rent roll, a debt quote and a partnership waterfall runs into days, and longer when documents arrive late. Most of that time is not analysis: it is reading an offering memorandum, a scanned rent roll and a trailing twelve month statement, typing them into a model, and then reconciling the three when they disagree.
- What does real estate underwriting software actually do?Real estate underwriting software turns a deal's source documents into a financial model and the documents an investment committee reads. Four jobs sit inside that: extracting figures from an offering memorandum, rent roll and operating statement; computing a cash flow, debt structure and return set correctly; letting an analyst change any assumption and see everything recompute; and producing an Excel workbook and a memo that reconcile to the model. A tool that does three of the four sends you back to a spreadsheet.
- How much does ARGUS cost?Altus Group does not publish a price list for ARGUS Enterprise, so no official figure exists to quote: you request a quote and it is negotiated per firm. Every number that circulates on third-party directories and industry forums is second-hand, and those numbers contradict each other, from a few thousand dollars per user per year at the low end to several times that at the high end, with one-time implementation and training commonly cited in the five-figure range. Seats, modules and contract term are what drive a quote, so the only figure worth budgeting against is the one Altus puts in writing for your firm.
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