Investment Analysis for Commercial Investment Real Estate
What is being tested
Investment analysis asks whether a deal creates value for the equity investor. Build a multi-year cash flow, add the reversion, and discount. Know the bridge: NOI less capital, TI, and leasing commissions gives cash flow before debt service; less debt service gives before-tax cash flow; adjust for income taxes to reach after-tax cash flow.
Concepts to master
- Reversion: terminal NOI divided by the exit cap rate, less costs of sale (typically 2–3%), less the loan balance, plus or minus tax on gain and depreciation recapture.
- Decision measures: NPV, IRR, equity multiple, and discounted payback. NPV is the value-maximizing rule; IRR is the most quoted.
- Leverage: positive when the going-in cap rate exceeds the loan constant; negative when it does not.
- Going-in versus going-out cap rate, and why the exit cap should widen for age and risk.
- Sensitivity and scenario analysis on rent growth, vacancy, exit cap rate, and interest rates.
Traps
- Ranking deals by IRR when scale or cash-flow timing differs; IRR assumes reinvestment at the IRR.
- Forgetting sale costs and loan payoff in the reversion, overstating equity proceeds.
- Comparing before-tax returns across deals with different tax profiles.
- Setting the exit cap equal to the going-in cap without justification.
- Assuming an equity multiple captures timing - it does not.
- Missing that leverage priced above the cap rate destroys return.
Worked example
A $10,000,000 purchase with $650,000 of first-year NOI yields a 6.5% going-in cap. A $7,000,000 loan at 6.0% with 25-year amortization has a loan constant near 7.73% and annual debt service of roughly $541,000. Equity is $3,000,000 and before-tax cash flow is $108,900, a 3.6% cash-on-cash return. Because 7.73% exceeds 6.5%, the debt is negative leverage.
Rule of thumb: compare the going-in cap rate to the loan constant first; if the constant is higher, adding debt lowers the equity return.