Real estate investment underwriting: test the income you are buying

Define the asset and the investment decision

Buying an occupied building is different from appraising a development site. The buyer is acquiring a particular ownership interest, lease structure, condition and set of obligations. Establish which property and income rights are included, the proposed acquisition date and the business plan. An apartment building held for steady income needs a different forecast from offices acquired for refurbishment and reletting.

Separate the seller's case from the buyer's underwriting. Preserve the original rent schedule and expenditure history, then show each adjustment with its reason. Replacing the seller's total with a more cautious total loses the explanation. A useful model allows another reviewer to trace exactly why expected collections, expenses or required works differ.

Reconcile contractual rent with collected rent

Build a line for each tenancy or an appropriately grouped set of units. Record occupied space, contractual rent, commencement and expiry, rent-free periods, review dates, deposits and arrears. Check material terms against executed documents and collections against the property accounts. A signed lease is evidence of an obligation; it is not proof that every scheduled payment has arrived.

Keep vacancy, concessions and collection losses distinct while preventing overlaps. If an effective rent already deducts a rent-free period, do not apply the same concession again below revenue. For space expected to relet, record the expected downtime, new rent, incentive and works needed. Treat unsupported future lettings as assumptions that can be changed, not as existing income.

The OCC handbook links income-property analysis to rent rolls, leases, tenant quality and lease expiries. It also distinguishes underwritten income from immediate cash and notes that covenant definitions can differ. This is US supervisory guidance; the actual loan agreement determines the applicable covenant calculation.

Sources: Office of the Comptroller of the Currency: Commercial Real Estate Lending: income-generating capacity and debt-service coverage

Follow one year from potential rent to investor cash

Consider an invented 20-unit rental property with annual potential rent of 480,000 currency units. Deduct 8% for combined vacancy and collection loss, then add 12,000 of separately evidenced other income. Effective gross income is 453,600. Owner-paid operating expenses of 150,000 leave net operating income, or NOI, of 303,600 under this example's definition.

Set aside 24,000 of annual cash for replacements and deduct scheduled debt service of 220,000, including principal and interest. Cash remaining for the owner is 59,600 before tax. The replacement amount is deducted only once: it is a funded allowance here, and spending paid from that account is not another owner cash deduction in this one-year screen.

Check the denominator behind each ratio

Assume a price of 4.8 million, acquisition costs of 0.2 million and initial works of 0.3 million. Total cash required is 5.3 million. A 3.2 million loan leaves 2.1 million of initial equity. The 59,600 annual owner cash represents 2.84% of that equity. This cash-on-cash screen excludes appreciation, sale proceeds, later capital calls and any reduction in debt outstanding as a separate return measure.

NOI divided by the price is 6.325%, but that property-income ratio is not the owner's cash return. It leaves acquisition costs, initial works, replacements and debt service outside the calculation. Showing the bridge prevents a headline yield from doing the work of a complete investment analysis.

For this example, NOI-based debt-service coverage is 303,600 divided by 220,000, or 1.38 times. Using cash after the replacement allowance gives 1.27 times. Neither is a universal lending threshold. Identify the required numerator and debt-service basis before comparing a result with a covenant or lender requirement.

Test the income alongside the building condition

Increase the combined vacancy and collection loss from 8% to 15%, holding other inputs constant. Effective income falls to 420,000, NOI to 270,000 and owner cash after the replacement allowance and debt service to 26,000. NOI-based coverage is 1.23 times. The annual cash cushion has more than halved even though operating expenditure has not risen.

A physical survey can change the replacement allowance, initial works or timing of vacant possession. RICS technical due diligence guidance addresses inspection of commercial property and the scope of that work. Commission the relevant expertise and bring costed findings into the cash forecast. A model cannot establish the remaining life of a roof or the adequacy of building services.

For a longer holding period, model lease breaks, renewals, capital work, financing changes and eventual disposal on their actual dates. Test whether a refinance assumption is still credible at maturity. Annual debt coverage does not by itself demonstrate that the final loan balance can be repaid.

Sources: RICS: Technical due diligence of commercial property

Finish with an evidence-backed acquisition record

Present the purchase price and all-in cost, reconciled starting income, adjustments to the seller's case, capital needs and funding assumptions. Identify the leases or expenses that could change the recommendation. Where the property is in another jurisdiction, replace tax, lease-enforcement and ownership assumptions with advice and documents relevant to that location.

The investment decision should state what has been verified, what remains conditional and how much room exists if the forecast disappoints. Comparing the price with a supported income stream is a starting point. The stronger question is whether the buyer can carry the property through the particular events that its leases, condition and debt introduce.