Financial Analysis for Commercial Investment Real Estate
What is being tested
Financial analysis questions ask you to rebuild a normalized operating statement and then test the property against lender and investor standards. Know the chain: potential gross income (PGI), less vacancy and credit loss, plus other income, equals effective gross income (EGI); EGI less operating expenses equals NOI; NOI less capital expenditures, tenant improvements, and leasing commissions equals cash flow before debt service.
Concepts to master
- Net lease mechanics: base years and expense stops, gross-up of variable expenses at stabilized occupancy, and recovery income.
- Expense classification: fixed, variable, and reserves; which items belong above versus below the NOI line.
- Ratios: operating expense ratio, DSCR, debt yield, LTV, break-even occupancy, cash-on-cash, and loan constant.
- Analytical methods: ratio analysis, trend analysis, and comparison against comparables.
Traps
- Excluding tenant improvements and leasing commissions because they are "below the line" - lenders still size loans on cash flow after those costs.
- Leaving non-recurring income (a one-time settlement, equipment sale) in stabilized NOI.
- Ignoring replacement reserves that underwriting requires even when the owner never funded them.
- Double counting recoveries, or grossing up expenses without adjusting income.
- Treating contract rent as market rent without checking expense structure and concessions.
Worked example
PGI is $1,000,000; vacancy and credit loss at 5% is $50,000; other income is $30,000, giving EGI of $980,000. Operating expenses of $400,000 (including a $25,000 reserve) produce NOI of $580,000. A $6,000,000 loan with a 7.58% loan constant carries $454,800 of annual debt service, so DSCR is 1.28 and debt yield is 9.7%.
Rule of thumb: value equals NOI divided by the cap rate, so $10,000 of NOI is worth roughly $154,000 at a 6.5% cap rate - small expense adjustments move price substantially.