Overview of Commercial Real Estate Underwriting
Overview of Commercial Real Estate Credit Underwriting
When a borrower seeks financing for a commercial real estate (CRE) project, lenders must assess whether the deal is sound. This process is known as commercial real estate credit underwriting. It’s a comprehensive analysis used to determine the viability of the loan based on the income-producing potential of the property, market dynamics, and borrower strength. At its core, underwriting aims to answer one key question: Can the property generate enough income to cover its debt obligations, even under stress?
CRE lending is a key component of most banks’ loan portfolios, particularly community banks where CRE loans often represent the largest share of loans. The interest income generated from these loans is a key driver of bank profitability, making loan origination, credit underwriting, and loan administration critical banking functions.
In this article, I break down the essential components of CRE credit underwriting, including Net Operating Income (NOI), Property Valuation and the Appraisal Process, the Debt Service Coverage Ratio (DSCR), and Stress Testing.
Net Operating Income (NOI)
Net Operating Income (NOI) is the cornerstone of CRE underwriting. It represents the income a property generates after accounting for all operating expenses, but before debt service and taxes. In essence, it’s the cash flow available to service debt and deliver returns to equity investors.
Formula:
NOI = Gross Operating Income – Operating Expenses
Gross Operating Income includes rental income and other income (e.g., parking, signage, storage).
Operating Expenses include property management, maintenance, insurance, property taxes, and utilities—but exclude mortgage payments, depreciation, and income taxes.
Lenders closely scrutinize the sustainability and quality of NOI to ensure it accurately reflects the property's ongoing earning potential. They often “normalize” NOI by adjusting for non-recurring income and abnormally low or irregular expenses—resulting in a more realistic view of the property's true financial performance.
In addition, lenders “stabilize” Gross Operating Income by incorporating reserves for anticipated tenant vacancies and credit losses, particularly if the property is not fully leased or if current leases are above-market. This adjusted income figure better reflects the expected long-term cash flow under market conditions.
Operating Expenses are also carefully reviewed and adjusted during underwriting. Lenders typically include standard allowances for items such as:
Capital replacement reserves (for major building components like roofs or HVAC systems)
Leasing commissions (to account for tenant turnover)
Property management fees
Owner-specific or discretionary expenses, which may be excluded if not applicable to a third-party operator
These adjustments ensure that NOI is calculated on a market-standard basis, providing a more accurate benchmark for evaluating loan feasibility and property value.
Property Valuation and Appraisal Process
Property valuation is a critical component of commercial real estate underwriting, as it reports on the market value of the real estate securing the loan. Lenders require an independent appraisal conducted by a certified appraiser to ensure objectivity and compliance with regulatory standards. The appraisal process is governed by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), which outlines strict guidelines for both appraisers and financial institutions.
Appraisals are typically based on one or more of the following valuation approaches:
Income Approach – Estimates the property’s value by applying a market-derived capitalization rate (Cap Rate) to its Net Operating Income (NOI). This method is most commonly used for income-producing properties such as multifamily, office, retail, and industrial assets.
Formula:
Value = NOI ÷ Capitalization Rate
Sales Comparison Approach – Determines value by comparing the subject property to recent sales of similar properties in the same market, adjusted for certain variances such as property size, condition, location, etc.
Cost Approach – Calculates value by estimating the cost to replace or reproduce the property, minus physical depreciation and obsolescence. The cost approach is essential for new construction and improvements, site development and special-use projects.
Lenders generally use the lower of the purchase price or appraised value when sizing the loan. This valuation plays a direct role in determining the Loan-to-Value (LTV) ratio—a key underwriting metric used to assess collateral adequacy and borrower equity.
For development, construction, or property rehabilitation projects, lenders will also evaluate the Loan-to-Cost (LTC) ratio, which compares the loan amount to total project costs. Both LTV and LTC are critical in determining the amount of required borrower equity and the overall risk profile of the transaction.
Typical CRE loans carry LTV ratios between 60% and 80%, depending on factors such as property type, asset class, market strength, and the lender’s risk appetite. For example, a stabilized Class A multifamily property in a strong market may support a higher LTV due to its lower risk. In contrast, an older office building with high vacancy or a property with a specialized use may require a lower LTV and greater equity contribution from the borrower.
The Appraisal: Three Approaches - "As Is," "As Complete," & "As Stabilized"
"As Is" Value – Represents the property’s current market value without assumptions of future improvements or lease-ups.
"As Complete" Value – Assumes construction or renovation is completed but before lease-up or stabilization.
"As Stabilized" Value – Reflects the property’s full market potential after reaching projected occupancy and income levels.
When forward-looking assumptions are involved, appraisers use Discounted Cash Flow (DCF) Analysis, adjusting future cash flows to present value using market interest rates and discount rates. Higher interest rates increase discounting, reducing projected values.
The Role of Capitalization Rates
As illustrated above, the Capitalization Rate (Cap Rate) is a key determinant of value in the Income Approach. Because the Cap Rate acts as a multiplier (or divisor, technically), even small changes can significantly impact a property's appraised value. For instance, a 0.25% shift in Cap Rate can alter valuations by hundreds of thousands or even millions of dollars, depending on the NOI.
Appraisers carefully document how the Cap Rate is derived, factoring in:
Property type and classification
Local market conditions and comparable sales
Current and projected interest rates
General economic outlook
Treasury yields and investor return expectations
Cap Rates tend to fluctuate in tandem with interest rates, particularly mortgage rates and Treasury yields, as they reflect the return investors demand from a given asset. Because of this, lenders pay close attention to Cap Rate trends, especially in volatile markets, as part of their risk assessment process.
Calculating the Debt Service Coverage Ratio (DSCR)
The Debt Service Coverage Ratio (DSCR) measures a property's ability to cover its debt payments with its operating income. It’s a critical risk metric in underwriting.
Formula:
DSCR = NOI ÷ Annual Debt Service
A DSCR of 1.0x means the property generates just enough income to cover debt payments.
Most lenders require a minimum DSCR of 1.20x–1.35x, depending on property type and loan structure.
For example:
If a property has $500,000 in NOI and annual debt service of $400,000:
DSCR = $500,000 ÷ $400,000 = 1.25x
A higher DSCR means more cushion for the lender in case of income fluctuations or unexpected expenses.
Stress Testing the Loan
Stress testing is used to assess how the loan would perform under adverse conditions. It helps lenders understand the downside risk by simulating scenarios like:
Declining rental income (e.g., loss of tenants)
Increased vacancy
Higher operating expenses
Rising interest rates on variable-rate loans
Lenders might model a 10–20% drop in NOI to see if the DSCR still meets the minimum threshold. For example, if the NOI falls to $450,000 in the previous example:
New DSCR = $450,000 ÷ $400,000 = 1.13x
If the loan falls below the lender’s DSCR requirement under stress, they may reduce the loan amount, require interest reserves, or adjust the amortization schedule to mitigate the risk.
Lenders also stress test property values to assess potential downside risk. As noted earlier, even small changes in capitalization rates (Cap Rates) can significantly impact property valuations due to their multiplier effect. Over the past few years, rising interest rates have led to an upward shift in Cap Rates, resulting in declining commercial real estate values across most asset classes.
This decline in value has caused Loan-to-Value (LTV) ratios on existing bank loans to increase, thereby heightening risk across lender portfolios. The office sector, in particular, has faced a double blow—first from rising interest rates compressing valuations, and second from declining tenancy and rental income, which in turn reduce Net Operating Income (NOI). These combined pressures have led to weaker underwriting metrics and increased credit exposure for many lenders.
Final Thoughts
Commercial real estate credit underwriting is a rigorous, data-driven process that blends property fundamentals, borrower strength, and macroeconomic factors. Core metrics like Net Operating Income (NOI), Debt Service Coverage Ratio (DSCR), property valuation, cost structure, and stress test scenarios guide lenders in evaluating risk and structuring appropriate financing solutions.
As I often emphasize, banks want to make loans—they need to deploy capital and leverage funding sources such as deposits to generate earnings. However, they must also apply prudent underwriting standards to protect against credit losses and ensure long-term financial soundness. When a bank underwrites a commercial real estate loan, it’s effectively placing a long-term bet—typically 5, 10, or even 15 years—on the asset’s ability to perform through changing market conditions.
Lenders look for stability, consistency, and resilience in the loan structure to minimize risk and maintain portfolio strength across economic cycles. The importance of disciplined underwriting is reinforced by the lasting impact of past disruptions, such as the 2007–2008 Financial Crisis and the more recent COVID-19 pandemic. These events exposed vulnerabilities in certain sectors—particularly office properties in major metros like New York City, where elevated vacancy rates persist.
In addition, inflationary pressures and rising interest rates have compressed property values and altered financing dynamics across the board. These headwinds underscore the continued need for rigorous underwriting grounded in market reality and long-term risk management.
Underwriting development and construction projects introduces additional complexity, as it must account for construction-related risks, absorption timelines, and cost overruns. This topic requires a deeper dive, which I will cover in a forthcoming article.
For real estate investors and developers, understanding the underwriting process is not just about securing approval—it’s a strategic advantage. A well-informed borrower can structure stronger deals, negotiate more effectively, and enhance project viability.
As an experienced commercial real estate credit officer, I bring deep insight into bank underwriting practices, credit policies, and loan structuring. I work with clients to navigate the financing process, prepare strong loan packages, and connect with appropriate lenders to achieve successful outcomes.
Need help preparing for a commercial real estate loan? Understanding underwriting standards is just the first step. A well-prepared financing package can significantly improve your chances of approval and optimize loan terms. Reach out to learn how our advisory services can support your next deal.
