Underwriting is utilized in nearly every aspect of real estate investing, from the investor buying or selling the property to the bank offering the loan. During the underwriting process, numerous words and abbreviations are commonly used that may not be in the lexicon of those not involved with underwriting on a regular basis.
Underwriting is the process of establishing both the risk and potential return of all types of investments, whether it be a real estate investor purchasing a building, a bank issuing a loan or an investment banker evaluating a stock.
To help alleviate some of the confusion surrounding the vocabulary used in underwriting, we have outlined the most common terms and definitions below.
Common Real Estate Underwriting Terms and Definitions
Gross Potential Income
Gross Potential Income (GPI) is the total potential income a property can produce each year if it is fully leased.
For example, a 100,000-RSF building with a full service rate of $40/SF/year has a GPI of $4 million. (100,000 RSF x $40/SF/YR = $4 million GPI)
This number is commonly used by underwriters as the starting point for the analysis. Operating expenses, vacancy and more will all be subtracted from GPI during the underwriting process.
Just like a residential property, commercial properties have recurring expenses related to owning and maintaining the building that must be paid every year. These costs are called operating expenses (Op/Ex) and include property taxes, insurance and common area maintenance, or CAM. Typically, what is included in CAM for office buildings is electricity, janitorial, management fees, etc.
To learn more about what can be included in CAM expenses for each property type, read our article What Are Common Area Maintenance (CAM) Fees?.
These expenses will be billed back to building tenants through their gross rent or operating expenses.
While every investor would like their building to be 100% leased at all times, most understand that a vacancy is likely to occur at some point during the investment period.
To account for this, the underwriter will factor in a cost of vacancy to provide a more realistic forecast of future cash flows. Standards will vary depending on market conditions and preference, but an allowance between 5% – 10% is not uncommon.
For example, if our 100,000-RSF building above has a vacancy allowance of 5%, the underwriter will deduct $200,000 from the annual GPI. ($4 million GPI * 5% Vacancy Allowance = $200,000)
Bad Debt Expense
Similar to a vacancy allowance, bad debt expense is a tool used by underwriters to account for the chance that a tenant will be late to pay rent or even default completely.
Bad debt expense could receive its own line in an analysis, or be combined with the vacancy allowance estimate. Like with a vacancy allowance, there is no standard adjustment for bad debt expense; underwriters rely mostly on market conditions and preference to gauge this metric.
For example, if our 100,000-RSF building has a forecasted bad debt expense of 5%, it will have $200,000 deducted from the annual GPI. ($4 million GPI * 5% Bad Debt Expense = $200,000)
Net Operating Income
Net Operating Income (NOI) is an important metric used when evaluating the profitability of a project or calculating its value. The NOI measures the actual income a building will produce in a year after operating expenses are paid. The NOI also factors in a vacancy allowance and bad debt expense, providing a realistic measure of what the building’s income will look like when not 100% occupied.
The Capitalization Rate (Cap Rate) is a fundamental metric used in valuing commercial real estate.
The Cap Rate is the annual percentage return of a property based on the future income (forward annual NOI) that the property will generate.
Due to the inverse relationship between cap rate and purchase price, a low cap rate (3% to 6%) will generally indicate a more expensive purchase, and a higher cap rate (7% to 10%) will indicate a comparatively more affordable one.
For example, assuming a forward annual NOI of $100,000 is held constant, a purchase price of $1,000,000 will yield a cap rate of 10% ($100,000/$1,000,000 = 10%), while a higher purchase price of $2,000,000 will yield a cap rate of 5% ($100,000/$2,000,000 = 5%).
Finding an estimated valuation (property value) for the investment is the ultimate goal of underwriting.
To do this, the underwriter will use the building’s forecasted annual NOI in conjunction with a desired cap rate to place a final dollar amount on the deal at hand.
In order to find the appropriate cap rate to use in this analysis, the underwriter will look at the cap rates of recently sold comparable buildings in the market, similar to how a residential real estate agent might look at recent home sales to determine what their client’s home is worth.
Essentially, if you know what you anticipate the building to produce each year, and you know what cap rate similar buildings are being sold at in your market, you can use these numbers to back in to the property value.
This value is generally the maximum an investor would be willing to pay for the property and can change during the negotiation process as variables are altered.
For example, if the underwriter knows the building’s forward annual NOI is $100,000, and also knows that similar buildings in the area have been sold with a cap rate of 5%, the underwriter can calculate that an appropriate price for the building in question is $2,000,000. ($2,000,000 = $100,000 / 5%)
Note: By rearranging this formula, you can also calculate a building’s cap rate if the NOI and purchase price are known. This can be useful when analyzing sale comparables to determine an appropriate cap rate for the property in question.
A stress test is a simulation technique which measures how an asset or liability will perform under different scenarios.
For example, an investor may run a stress test by inputting different predicted rental rates to see how it will impact a project’s forecasted return, or may vary the estimated vacancy rate to show if the project will still be profitable if demand is lower than anticipated.
When using a loan to fund an investment, it is common for the lender to only fund a percentage of the investment’s total value. This percentage, the Loan-to-Value (LTV) ratio, can be used to calculate the amount of debt, and thus the amount of equity, required for the investment.
For example, if the investment’s value is $100M and the lender will only offer 70% LTV, the investor will receive $70M of debt and be required to fund the remaining $30M with equity.
Because most lenders will not fund 100% of an investment’s value, the investor will usually need to provide equity to make up the difference. Investors will generally try to limit the amount of equity required, due both to a limited amount of cash and the financial benefits of using debt (also known as leverage) in transactions.
The equity required can be found by finding the difference between the purchase price and the loan amount.
Debt Service Coverage Ratio
The Debt Service Coverage Ratio (DSCR) is the ratio of a property’s NOI to it’s annual mortgage.
For example, a property with a NOI of $125,000 and an annual mortgage debt service of $100,000 will have a DSCR of 1.25.
This metric is the first thing lenders will consider when determining the loan amount they are able to lend. A higher ratio means a lower risk of default, and because of this, projects with higher ratios may be able to obtain larger loans.
Net Present Value
Net Present Value (NPV) is a metric used to value future cash flows of an investment by discounting the cash flows to their present value.
Due to the time value of money and uncertainty of the future, cash flow tomorrow is not as valuable as an equivalent cash flow today.
To account for this in the underwriting process, the projected cash flow of the investment is “discounted” by a discount rate (usually between 6%-15% for an office project depending on the risk profile of the investment and the buyer’s cost of capital).
NPV combines all future cash flows of an investment and presents them as a value in today’s dollars. This is used as a way to not only gauge whether the investment will generate revenue, but whether that revenue will be of value after taking into account the time and risk it takes to receive it.
|Year 0||Year 1||Year 2||Year 3|
|Discounted Cash Flow||$100,000||$90,909||$82,645||$75,131|
Internal Rate of Return
Internal Rate of Return (IRR) is a metric used to estimate the profitability of potential investments. It is the discount rate that makes the NPV of all cash flows from a particular project equal to zero, giving the investor a benchmark for a break-even return. If the IRR is higher than the chosen discount rate, the NPV will be positive, indicating that the investment will produce more money than was originally invested. In general, the investment with the highest IRR is the one the investor should pursue.
IRR provides a concise overview of an investment’s return over the entire holding period and is a commonly used tool in the world of underwriting. This, when combined with an NPV analysis, helps an investor understand the value of an investment in terms of today’s dollars. For more information on what IRR is and how it is calculated, read more here.
Return on Cost
This value represents the annual return of the project as a whole, not taking into account the amount of debt or equity used to make the initial acquisition. Return on cost is to be used for the purchase of an existing, stabilized building.
For example, if a building has an annual NOI of $100,000 and the purchase price of the building was $2,000,000, the return on cost per year is 5%.
Note: While Return on Cost and Cap Rate are very similar, the difference lies in how they are used. Return on Cost is used when evaluating the investment through the owner’s holding period, while Cap Rate is used as a tool for valuing a building. For example, an investor wanting to know what yield the building will generate in Year 3 would ask to see the Return on Cost, not the Cap Rate.
Stabilization is a term commonly used in development projects to indicate a building that has reached a “stable” stream of income by having a certain percent of the building leased. This percentage will depend on the class of the asset and the type of building, but, in general, 95% leased is considered “stabilized” for an office building.
Developers aim to reach stabilization as quickly as possible once construction is complete.
Development Yield is essentially the Return on Cost of a development project upon stabilization.
For example, if a project reached a stabilized annual NOI of $100,000 and costed $2,000,000 to build, the annual development yield would be 5%.
Return on Investment
Return on Investment (ROI), also referred to as the Return on Equity, is a measure of the cash flow that is returned to the investor.
It is equal to the Annual Distributable Cash Flow to the investor (NOI minus all capital expenses and debt service payments) divided by the equity invested in the project.
As you can see, there are a multitude of terms utilized in the underwriting process that are likely not in the lexicon of those new to the process. Learning these definitions can be a hurdle to overcome, but doing so is a worthwhile endeavor for anyone interested in commercial real estate investing.
If you would like to learn more about the underwriting process or are looking for assistance in underwriting your own investment, our experienced investment services team will be happy to lend a hand.
Or to read more about the process of underwriting a real estate property, read our article Evaluating a Property: Underwriting Commercial Real Estate Acquisitions.
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