7 Key Metrics for Commercial Real Estate Underwriting
Want to make smarter real estate investments? Here are 7 must-know metrics that can help you assess a property's value, income potential, and risks quickly:
Net Operating Income (NOI): Measures how much income a property generates after operating expenses.
Cap Rate: Evaluates return on investment by comparing NOI to market value.
Debt Service Coverage Ratio (DSCR): Shows if a property’s income can cover its debt payments.
Loan-to-Value (LTV): Compares loan amount to property value to assess lending risk.
Debt Yield: Helps lenders understand the risk by calculating how much income a property generates relative to its debt.
Internal Rate of Return (IRR): Tracks total investment returns over time, factoring in cash flow and appreciation.
Operating Expense Ratio (OER): Reveals how efficiently a property is managed by comparing expenses to income.
These metrics work together to provide a full picture of a property's financial health and investment potential. Whether you’re buying, selling, or underwriting, mastering these tools can help you make informed decisions.
A 7-Step Framework For Underwriting Commercial Real Estate
1. Net Operating Income (NOI)
Net Operating Income (NOI) is a key metric in commercial real estate. It shows how much income a property generates before factoring in financing costs or taxes.
How to Calculate NOI
To calculate NOI, start with Effective Gross Income (EGI) and subtract Operating Expenses:
Net Operating Income = Effective Gross Income - Operating Expenses
Here’s the breakdown:
Effective Gross Income (EGI):
Begin with Potential Rental Income
Subtract Vacancy and Credit Losses
Add Other Income (e.g., parking fees, vending machines)
Operating Expenses:
Property management fees
Utilities
Insurance
Property taxes
Maintenance costs
Administrative expenses
“Net operating income (NOI) is a key performance metric in commercial real estate that measures a property’s ability to generate income by calculating the total operating income minus the total operating expenses.”
Why NOI Matters
NOI is a vital tool for:
Measuring a property’s performance without factoring in ownership or financing.
Accurately estimating property value.
Comparing different properties on a level playing field.
Serving as the foundation for calculations like cap rate and DSCR.
What’s Excluded from NOI?
NOI does NOT include:
Debt service payments
Income taxes
Depreciation
Capital expenditures
Tenant improvements
Leasing commissions
Example: Calculating NOI
Here’s a practical example for a multi-tenant office building:
Income/Expense Category | Annual Amount
Potential Rental Income | $500,000
Vacancy Loss (5%) | ($25,000)
Other Income | $30,000
Effective Gross Income | $505,000
Property Management | ($30,000)
Utilities | ($45,000)
Insurance | ($15,000)
Property Taxes | ($40,000)
Maintenance | ($25,000)
Total Operating Expenses | ($155,000)
Net Operating Income | $350,000
“The net operating income is useful because it describes a property’s ability to generate income without considering its capital structure.”
Understanding Stabilized NOI - what the income would be at full occupancy - can guide long-term decisions. With NOI as the foundation, you can build a more detailed underwriting analysis.
2. Cap Rate Basics
Cap Rate is a simple way to measure a property's return on investment. It helps investors compare properties and evaluate risk levels effectively.
How to Calculate Cap Rate
The formula for Cap Rate is straightforward:
Cap Rate = Net Operating Income (NOI) / Current Market Value
For example, if a property has an NOI of $350,000 and a market value of $5,000,000:
$350,000 ÷ $5,000,000 = 0.07 or 7%
Using Cap Rate in Analysis
Cap Rate serves as a quick snapshot of both performance and risk. Here's a breakdown of what different Cap Rates generally suggest:
Cap Rate Range | Risk Level | Property Characteristics
4% - 5% | Low Risk | High-end properties, prime locations, reliable tenants
5% - 7% | Moderate Risk | Mid-tier properties, good locations, mixed tenant types
7%+ | Higher Risk | Older properties, secondary markets, potential challenges
“Cap rate is a key metric for real estate investors to evaluate the profitability of a property. It provides a simple and effective way to determine the potential rate of return an investor can expect to earn on their investment based on the property’s net operating income (NOI) and its market value.”
Cap Rate Examples
Here’s how Cap Rates vary across property types, based on market data:
Multifamily Properties: Average Cap Rate of 4.9%. These properties typically offer steady income with lower risk.
Retail Properties: Average Cap Rate of 6.7%. Reflects a mix of market uncertainty and tenant variability.
Office Properties: Average Cap Rate of 6.8%. Higher returns but often tied to market challenges.
Interestingly, while Cap Rates of 10% were common in the late 1990s, today’s investors generally expect returns between 4% and 7% for high-quality commercial properties [3].
3. Debt Service Coverage Ratio
DSCR measures whether a property's Net Operating Income (NOI) is enough to cover its debt obligations, making it a critical factor in lending decisions.
How to Calculate DSCR
To calculate DSCR, divide the property's NOI by its Annual Debt Service. For example, if the NOI is $120,000 and the Annual Debt Service is $100,000, the DSCR is 1.20x. This means the property generates 20% more income than needed to cover its debt.
How Lenders Use DSCR
Lenders use DSCR to evaluate loan risk and decide how much they’re willing to lend. Different property types have specific DSCR requirements based on their risk levels:
Property Type | Minimum DSCR Requirement | Notes
Multifamily | 1.20× to 1.25× | Steady income, lower risk
Office Buildings | 1.25× | Long-term, predictable leases
Industrial Properties | 1.25× to 1.35× | Sensitive to economic fluctuations
Retail Centers | 1.30× to 1.40× | Income tied to consumer spending habits
Hotels | 1.40× to 1.50× | Seasonal and market-dependent income
Higher DSCR thresholds give lenders more confidence.
For instance, a DSCR of 1.20x means the property could handle a 16.7% drop in NOI and still cover its debt obligations [4].
DSCR in Action
Let’s look at an example of a stabilized apartment complex:
NOI: $240,000
Annual Debt Service: $141,000
DSCR: 1.70x
This high DSCR indicates strong, stable operations, which would likely meet most lenders' benchmarks for multifamily properties.
Lenders often refine their assessments by adjusting NOI. For instance, they might add back certain non-cash expenses like replacement reserves or management fees to get a clearer picture of the property's financial health.
4. Loan-to-Value (LTV)
Loan-to-Value (LTV) measures the relationship between the loan amount and the property's value. It helps lenders evaluate risk and decide on loan terms for commercial real estate investments.
How to Calculate LTV
Calculating LTV is simple: divide the loan amount by the property's value, then multiply by 100.
LTV = (Loan Amount / Property Value) × 100
For example, if a loan is $1,500,000 and the property is worth $2,000,000, the LTV would be 75%.
LTV in Lending Decisions
Different types of properties have varying maximum LTV limits based on their risk profiles and market factors:
Property Type | Typical Maximum LTV | Risk Factors
Multifamily | 75–80% | Consistent income, strong demand
Office | 65–75% | Tenant quality, market location
Industrial | 65–75% | Economic fluctuations
Retail | 65–70% | Dependence on consumer spending
Special Use | 60–65% | Limited resale potential
Higher LTV ratios often lead to higher interest rates, tighter loan terms, the need for mortgage insurance, or additional documentation requirements.
Examples of LTV in Action
Class A Office Building
Property Value: $10,000,000
Loan Amount: $7,000,000 (LTV: 70%)
Result: Due to the high-quality asset, the borrower may secure favorable loan terms.
Retail Strip Center
Property Value: $5,000,000
Loan Amount: $3,500,000 (LTV: 70%)
Result: Lenders might require extra reserves because of the risks tied to retail properties.
Lenders use various methods to assess a property's value, which directly impacts the LTV ratio. Common valuation approaches include Fair Market Value (FMV), Orderly Liquidation Value (OLV), and Forced Liquidation Value (FLV).
For example, a property with an FMV of $4,000,000 might have an OLV of only $3,200,000. Even with the same LTV percentage, the loan amount would be lower if the OLV is used, reflecting a more cautious approach to risk.
Understanding LTV analysis is a key part of evaluating risk and making informed lending decisions, complementing other underwriting metrics.
5. Debt Yield
Debt yield focuses on evaluating income performance without being influenced by market changes. It's a key metric for lenders to gauge loan risk, independent of market conditions, interest rates, or repayment schedules. Essentially, it shows how quickly a lender could recover their investment if a borrower defaults.
How to Calculate Debt Yield
The formula for debt yield is straightforward:
Debt Yield = (NOI / Loan Amount) × 100
For example, if the Net Operating Income (NOI) is $1,000,000 and the loan amount is $10,000,000, the debt yield would be 10%.
Using Debt Yield in Analysis
Lenders rely on debt yield to assess risk, with benchmarks varying by property type and market conditions. Here are some common standards:
Asset Type | Minimum Debt Yield | Typical DSCR
Office | 12% | 1.45
Retail | 10% | 1.40
Multifamily | 8% | 1.25
In times of rising interest rates, lenders often increase their minimum debt yield requirements to mitigate risk. For most commercial properties, a 10% debt yield is seen as the baseline. However, for more stable asset types like multifamily properties, lenders may accept yields as low as 6.5% to 8.5%.
Debt Yield Examples
Class A Office Building
NOI: $200,000
Loan Amount: $1,600,000
Debt Yield: 12.5%
A debt yield of 12.5% indicates lower risk, making the loan attractive to lenders even under stricter criteria.
Retail Strip Center
NOI: $100,000
Loan Amount: $1,600,000
Debt Yield: 6.25%
With a 6.25% debt yield, the risk appears higher. Lenders might respond by reducing the loan amount or requiring additional safeguards.
For reference, a 12% debt yield means the lender could recover their full loan amount in about 8.3 years purely from the property's income, regardless of changes in market value. Debt yield is another valuable tool in an underwriter's arsenal for assessing property risk.
6. Internal Rate of Return
Internal Rate of Return (IRR) is a metric used to evaluate an investment's total return while factoring in the time value of money. Unlike simpler measures like cap rates or cash-on-cash returns, IRR offers a more detailed perspective on how an investment performs over its entire lifespan.
Understanding IRR
IRR reflects the annual percentage return on every dollar invested. It’s calculated by identifying the rate that makes the net present value (NPV) of cash flows equal to zero. While the math can be complex, modern tools make IRR calculations straightforward.
Here’s a simple example: If you invest $100,000 today and it grows to $161,051 in five years, the IRR for that investment is 10% [6].
Several factors contribute to IRR:
IRR Component | Description | Contribution to Return
Initial Investment Recovery | Return of the original equity invested | Primary factor
Year 1 Cash Flow | Operating cash flow in the first year (NPV) | Immediate income generation
Cash Flow Increases | Growth in operating income over time | Boosts returns during hold
Appreciation | Rise in property value | Adds value primarily at exit
Principal Reduction | Decrease in loan balance (NPV) | Builds equity over time
Using IRR in Analysis
IRR helps investors compare investment options of varying sizes and durations. In commercial real estate, it’s used to analyze:
Levered vs. Unlevered Returns: Comparing returns with and without debt financing.
Hold Period Impact: Understanding how the length of time an investment is held affects returns.
Risk Assessment: Breaking down return sources to identify and manage risks effectively.
This level of detail makes IRR a powerful tool for evaluating investment opportunities alongside other key metrics.
“The internal rate of return (IRR) is the preferred return metric in commercial real estate investment analysis. This calculation allows real estate investors to compare multiple investments of varying sizes and objectively evaluate these investment opportunities.”
IRR Examples
Initial Investment: $3,811,000
Hold Period: 5 years
Leveraged IRR: 15.29%
Breakdown of present value components:
Initial Investment Recovery: $1,871,422
Year 1 Cash Flow (NPV): $233,736
Cash Flow Increases (NPV): $391,132
Appreciation (NPV): $892,536
Principal Reduction (NPV): $422,174
A smart way to manage risk is by diversifying the sources of IRR. Relying on a mix of returns - rather than depending heavily on one factor - can provide stability during market downturns while still delivering strong performance.
Next, we’ll explore the Operating Expense Ratio to gain deeper insights into property performance.
7. Operating Expense Ratio
The Operating Expense Ratio (OER) is a key metric that evaluates a property's operational efficiency. It does this by comparing the property's operating expenses to its gross operating income. This metric builds on other financial indicators like DSCR and Debt Yield.
How to Calculate OER
The formula for OER is:
OER = (Total Operating Expenses ÷ Gross Operating Income) × 100
Operating expenses typically include:
Property taxes
Insurance
Utilities
Repairs and maintenance
Property management fees
However, it excludes costs like depreciation, debt service, and capital expenditures. Gross operating income includes revenue sources such as rent, parking fees, and other income streams.
Using OER in Analysis
OER helps identify operational inefficiencies and allows for property comparisons across markets. Different property types have varying OER benchmarks:
Property Type | Typical OER Range
Industrial | 15% to 25%
Multifamily | 35% to 45%
Office Buildings | 35% to 55%
Retail Properties | 50% to 70%
Property managers can lower OER by implementing energy-efficient systems, staying on top of maintenance, and optimizing vendor contracts.
OER Example
Take a Class A office building in downtown Seattle with the following financial details:
Annual Operating Expenses: $850,000
Property taxes: $300,000
Insurance: $75,000
Utilities: $225,000
Maintenance: $150,000
Management fees: $100,000
Gross Operating Income: $2,000,000
The OER calculation would be:
OER = ($850,000 ÷ $2,000,000) × 100 = 42.5%
This result fits within the expected range for office properties, showing that the property is being managed efficiently.
“OER is a crucial metric used in commercial real estate to assess a property’s operational efficiency.”
Investors should compare OER against similar properties and keep an eye on trends to catch potential issues early.
Conclusion
Bringing everything together, the metrics outlined earlier form the backbone of a solid investment strategy. Successful underwriting hinges on applying these financial metrics in a thoughtful, well-rounded way. While each metric offers unique insights, their real power lies in evaluating them as a group.
Here’s how they work together: NOI and Cap Rate establish income potential, DSCR and LTV evaluate lending risk, Debt Yield provides an extra layer of risk assessment, IRR projects long-term returns, and OER gauges operational efficiency.
To put these strategies into action: cross-check seller data with independent sources, rely on conservative projections, analyze metrics in the context of current market conditions, and keep an eye on trends over time. This approach enhances the accuracy and reliability of your underwriting process.
Ongoing analysis is key to refining your methods and managing risk effectively.