Commercial Real Estate Investment Analysis – Are the Numbers Real?


Key Takeaways

Key Takeaways

  • Commercial real estate property sales, especially the larger ones, tend to be handled by a professional real estate broker
  • As part of the representation of the property, the broker performs their own financial due diligence and uses it to create a proforma financial projection of the property’s operational performance.
  • However, it is important to remember that the point of the broker’s projection is to make the property appear in the best possible light so they can sell it.  Thus, it is important to take a closer look at their numbers to determine “if they are real.”
  • To do this, a significant amount of time and resources are invested in reviewing broker projections and comparing them to our own.  This process includes things like looking at rent and expense increase assumptions along with vacancy to determine if they are supported by market data.
  • The aim of this due diligence is to determine if the property’s asking price is fully supported by market comparables and historical data.

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Every commercial real estate (“CRE”) transaction in the United States follows a similar lifecycle, a property is discovered, a significant amount of due diligence and underwriting is performed to ensure the asset is investable, an offer is made, and the transaction is closed.  While each of these phases of the transaction is important, perhaps none is more so than the due diligence/risk assessment phase, the purpose of which is to determine the answer to a key question, “are the numbers real?”

Commercial Real Estate Marketing Materials

One of the primary reasons that an investor needs to determine if the “numbers are real” is that they are trying to filter through all of the sales spin on the property and get to a fact based assessment of the financial performance.

The primary sales document that comes with most commercial real estate properties is something called an “Offering Memorandum.”  In most cases, it is a lengthy, dense document that contains all of the information that a potential investor would want to know about the property.  Most importantly, it contains a financial projection or “proforma” of the property’s financial performance and cash flow over a certain period of time.  The following screenshot is an example of a proforma from an actual Offering Memorandum.

From the screenshot, it can be seen that the listing broker has taken the time and put forth the effort to underwrite the deal on their own and create a projection of the property’s performance.  However, this projection is based on the opinion of the listing broker/seller and is meant to justify the asking cap rate and valuation.  The numbers may or may not be fully supported by historical data.  So, when we ask, “are the numbers real”, what we are really asking is “are they supported by actual historical data,” which includes the assumptions used to create the projection.  In our experience, there are a few tell tale signs that a proforma projection is aggressive or unsupported by historical data.  Here is what we look for:


  • Substantial Rent Increases:  In a value-add property, it is common for the broker to model significant rental increases early in the holding period.  For example, in the screenshot above Gross Potential Rent jumps from $652k to $704k between years 1 and 2.  While this is definitely possible, it likely depends on a series of events that may or may not actually happen.  We prefer to see a “smooth” increase where the rents go up incrementally each year, which is a more sustainable scenario.
  • Rental Increase Assumptions: All proformas include an assumption that the rent will go up each year once the property is stabilized.  3% is a common choice, but it may not always be supported by data in the local market.  We like to see the basis for the rental increase assumption, which includes historical market/submarket data.
  • Expense Increase Assumptions:  Similarly, a proforma typically includes assumptions about how much expenses will increase each year.  1.5% – 2.0% is a common choice, but these may not be supported by historical data either.  For example, property taxes can increase significantly after a purchase or an extra cold winter or extra hot summer can cause a dramatic rise in utility bills.  We like to see a multi-year trend of the property’s financial performance to ensure this assumption is supported.
  • Vacancy Assumptions:  A property’s “vacancy” represents the percentage of the space that is unoccupied (with no rent being paid) at any given time.  Often, especially in a value-add project, the property will have a high vacancy percentage at the time of purchase and an assumption is made that it will decrease once the property is stabilized.  But, it doesn’t always happen this way.  On occasion, it can take longer than estimated or it doesn’t go down as far as projected.  Commonly, 5% – 7% is a choice for the stabilized vacancy percentage.  But, if a property starts at 20%, we like to see it go down slowly over time to this stabilized range rather than make an unsupported jump from 20% in Year 1 to 5% in year two.  Again, this is possible, but we prefer a more data based approach.   

Through decades of experience and hundreds of deal reviews, we are able to pick up on the nuances and tricks used in an Offering Memorandum to make a property look better than it really may be.  Rather than trust it completely, we like to use the Offering Memorandum as a starting point for our own analysis.

Due Diligence – Our Own Analysis

In the due diligence phase of the transaction, our own analysis is focused on reviewing each line item in the proforma projection and reconciling it with the property’s historical performance.  To that end, we begin the due diligence phase by asking the seller or their broker for a series of documents including: 

  • Current rent roll 
  • Profit & loss statement for the previous (“trailing”) 12 months 
  • Copies of actual bills for utilities, property management, and property taxes
  • Copies of leases for each individual tenant 

With this information, our underwriter(s) and analyst(s) we will get to work comparing historical data to forward looking projections.  This process can be time consuming and complicated, but it can reap significant rewards when/if an anomaly is discovered.  For example, the current rent roll is a listing of all of the tenants in the property and the amount that they pay each month in rent.  The sum of these monthly rental amounts, multiplied by 12, should match the current year projection of income for the target property.  If it doesn’t, then it is necessary to dig in and figure out why the discrepancy exists and how to normalize it in our own projection.

Why Our Own Due Diligence Matters

Unlike residential assets, which are valued based on the sales of comparable properties, commercial properties are valued on the amount of Net Operating Income (NOI) that they produce in a given year.  The higher the Net Operating Income, the higher the value.  For this reason, it is critically important to perform our own financial projections, informed by years of experience and hundreds of transactions, to ensure that we do not unintentionally pay a higher than market value for the property, which could limit the returns that we are able to deliver to our investors.  If a significant discrepancy is found in the due diligence phase, we will go back to the seller to renegotiate the price to a level we deem acceptable.

The other major reason that due diligence is critical is to prequalify the deal before taking it out to lenders for a commercial real estate loan.  In order to not waste the lender’s time, it is important to be a good borrower by performing our own loan underwriting to ensure the deal meet’s the minimum loan requirements for loan-to-value (LTV), debt service coverage ratio (DSCR), loan amount, interest rate, property value, and tenant creditworthiness. 

Interested in Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help.  If you’d like to learn more about our middle market retail investment opportunities, contact us at (800) 605-4966 or for more information.

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