Underwriting Commercial Real Estate Loans: A Practical Guide

Underwriting a commercial real estate loan is the work a lender does to answer one question: will this property produce enough cash to repay this loan, even if things go sideways? The same handful of tests decide most files, and you can run every one of them yourself before you send a request to a lender. This guide walks through each test in the order an underwriter uses it, with real numbers, then answers the questions borrowers ask most.

How do lenders underwrite commercial real estate loans?

Lenders underwrite two things at once: the property and the borrower. For the property, they rebuild net operating income, then size the loan three ways (debt service coverage, loan to value, and loan to cost) and approve the lowest result. For the borrower, they apply the 5 C's of credit: character, capacity, capital, collateral, and conditions. Finally, they stress the deal to see whether it survives higher vacancy or higher rates. Every section below is one of those steps.

Step 1: What is NOI and how do underwriters calculate it?

Net operating income, usually written as NOI, is the income the property produces after operating expenses and before debt payments. Start with gross rental income, subtract a vacancy allowance, add other income such as parking or laundry, then subtract operating expenses like taxes, insurance, utilities, management, repairs, and reserves. Do not subtract the mortgage payment, capital improvements, or depreciation.

Underwriters rarely accept your NOI at face value. They re underwrite it using market vacancy, a market management fee, the tax bill after reassessment, and a replacement reserve per unit or per square foot. If your projection is thinner than the market, the lender's NOI will come in lower than yours.

Step 2: What DSCR do lenders require?

The debt service coverage ratio, or DSCR, is NOI divided by annual debt service. A property with 120,000 dollars of NOI and 100,000 dollars of annual payments has a DSCR of 1.20, meaning it produces twenty percent more cash than the loan requires. Most lenders want at least 1.20 to 1.25 on stabilized property, and more on riskier asset types, single tenant buildings, or short leases.

DSCR is usually the test that limits loan size. If the ratio comes in short, the loan amount comes down, the term stretches, or the deal needs more equity.

Step 3: What LTV and LTC will a lender allow?

Loan to value, or LTV, is the loan amount divided by the appraised value. Loan to cost, or LTC, is the loan amount divided by total project cost, including purchase, construction, soft costs, and carry. Stabilized acquisitions are typically capped near sixty five to seventy five percent LTV. Construction and heavy renovation deals are usually sized on LTC, often near sixty five to eighty percent depending on the lender and the sponsor.

Step 4: Why does the lowest test set the loan amount?

The approved loan is the lowest number the tests produce, not the highest. A file can clear LTV comfortably and still be cut by DSCR, or the reverse. Run all of them before you set expectations with a seller or a partner.

A worked example: sizing a loan on a mixed use building

Take a Philadelphia mixed use building with a storefront and four apartments, priced at 1,500,000 dollars.

1. Income. Gross rent is 168,000 dollars a year. The lender applies a seven percent vacancy allowance, about 11,760 dollars, leaving 156,240 dollars. 2. Expenses. Taxes, insurance, utilities, repairs, a five percent management fee, and reserves total 52,000 dollars. 3. NOI. 156,240 minus 52,000 equals 104,240 dollars. 4. DSCR test. At a 1.25 minimum, the property can support 83,392 dollars of annual debt service. At a seven percent rate on a twenty five year amortization, that supports a loan of roughly 985,000 dollars. 5. LTV test. The building appraises at the purchase price. At seventy five percent LTV, the cap is 1,125,000 dollars. 6. Result. The lower number wins. The loan is sized near 985,000 dollars, about sixty six percent of value, so the buyer needs roughly 515,000 dollars plus closing costs, not the 375,000 dollars a pure LTV estimate would suggest.

That gap is the most common surprise in commercial lending, and it is the reason to run DSCR first.

What are the 5 C's of credit? Examples from real loan files

The 5 C's of credit are how lenders underwrite the borrower alongside the property. Two identical buildings get different answers when the people behind them are different. Here is what each C means and what it looks like in a file.

1. Character. Your credit history and track record of repaying debt. Example: a borrower with a 720 credit score and no late payments in five years reads as reliable. A borrower with a recent charge off needs a written explanation and proof the issue is resolved. 2. Capacity. Your ability to repay from cash flow, measured by DSCR on the property and global cash flow across everything you own. Example: a property at 1.35 DSCR is strong, but if another building in your portfolio is losing 40,000 dollars a year, the lender counts that loss against you. 3. Capital. The money you put in and the liquidity you keep after closing. Example: a buyer who brings a 25 percent down payment and still holds six months of payments in reserve is far stronger than one who drains every account to close. 4. Collateral. The property and any other assets securing the loan. Example: a fully leased building on a busy commercial corridor is better collateral than a vacant special use property, even at the same appraised value, because it is easier to sell if the loan fails. 5. Conditions. The loan purpose, the market, and the terms. Example: a lender may approve a purchase of a stabilized apartment building quickly but ask for more equity on a ground up restaurant project in a submarket with rising vacancy.

Experience with the same asset type often decides close calls. A first time investor can strengthen character and capacity with a partner or guarantor who has done the work before.

How does the cap rate affect the appraised value?

Divide NOI by the capitalization rate and you get an income based value. At a six percent cap rate, 120,000 dollars of NOI supports a two million dollar valuation. At a seven percent cap rate, the same NOI values the property near 1.71 million, which can move a loan by hundreds of thousands of dollars. Use cap rates from recent comparable sales in the same submarket and asset class, not a national average.

How do underwriters stress test a deal?

Every credit committee asks what happens if the deal underperforms. Model vacancy two or three points above your base case. Raise the interest rate one or two points at refinance. Add a realistic lease up period instead of assuming full occupancy on day one. Check taxes after reassessment. If DSCR stays above 1.0 under those conditions, your file is defensible. If it does not, you know the weak point and can address it in the package before an underwriter finds it.

What documents do you need for a commercial real estate loan?

Most delays are document delays, not credit problems. Have these ready before you apply:

1. Rent roll and copies of current leases 2. Trailing twelve months of operating statements 3. Two or three years of property and business tax returns 4. Personal financial statement and personal tax returns for each guarantor 5. Purchase agreement or current mortgage statement 6. Scope of work and budget for any construction 7. Entity organizational chart and formation documents

A complete package is the cheapest way to shorten a closing timeline.

Frequently asked questions

How long does commercial real estate underwriting take?

Most banks and community lenders take two to six weeks from a complete package to a credit decision, plus time for the appraisal and environmental report. Incomplete packages are the main cause of longer timelines.

What credit score do you need for a commercial real estate loan?

Many lenders look for 680 or higher from each guarantor, but property cash flow and liquidity carry more weight than in a home mortgage. Community development lenders often work with lower scores when the rest of the file is strong.

What is a good DSCR for a commercial loan?

A DSCR of 1.25 or higher is considered good for most stabilized property. Anything below 1.0 means the property does not cover its own debt payments.

Can a first time investor get a commercial real estate loan?

Yes. Lenders will ask for more equity, more reserves, or an experienced partner or guarantor, and smaller mixed use buildings are often the easiest place to start.

What is the difference between LTV and LTC?

LTV compares the loan to the appraised value of the property. LTC compares the loan to the total cost of the project. Lenders use LTV for purchases and refinances of stabilized property and LTC for construction and renovation.

Run the numbers on your own deal

I built underwriting software so owners and investors can see NOI, DSCR, LTV, LTC, and stress cases in minutes instead of rebuilding a spreadsheet for every deal. If you are in Philadelphia, the Philadelphia small business loans FAQ explains where local borrowers find capital, and the CDFI loans explainer covers community lenders that often say yes when banks say no.

See how the underwriting software works.