Every commercial property comes with a story, and the seller is the one telling it. The listing says the building earns $120,000 a year. The broker’s flyer says it’s priced at an 8% cap rate. It all looks clean and simple.
In more than 40 years of buying, managing and advising on commercial property, I’ve learned that the numbers on the flyer are where my work starts, not where it ends. Most bad deals I’ve seen weren’t bad buildings. They were good buildings bought at the wrong price because the buyer believed the seller’s version of the numbers.
The good news is that you don’t need a finance degree to read commercial property financials. You need to know which documents to ask for, what to look for in each one, and a handful of simple calculations. That’s what this post covers. By the end, you’ll be able to take a seller’s numbers, rebuild them the way a lender would, and know what the property is really worth to you.
The Documents to Ask the Seller For
Before you run a single number, get the right paperwork. A broker’s offering memorandum is a sales piece. It’s useful for a first look, but it’s not proof of anything. Ask for these:
- Rent roll. A current list of every tenant, their space, their rent and their lease dates.
- Trailing 12-month operating statement (the “T-12”). What the property actually took in and spent over the last 12 months, month by month.
- Two or three years of annual operating statements. These show the trend. Is income growing, flat or slipping?
- Copies of the leases. The rent roll is a summary. The leases are the contracts that actually control the money.
- Property tax bills and insurance declarations. So you can check the two biggest fixed expenses yourself.
- Service contracts and utility bills. Landscaping, trash, snow removal, HVAC maintenance and so on.
If a seller won’t share a T-12 or the leases, that tells you something. Serious sellers expect serious buyers to ask. You can make your offer subject to receiving and approving these documents, which I cover in my post on the letter of intent.
How to Read the Rent Roll
The rent roll is where I start, because income is what you’re buying. For each tenant, look at:
- Square footage and rent per square foot. Commercial rent is usually quoted per square foot per year. If one tenant pays far more than the others, ask why. That rent may not survive a renewal. (Here’s more on how commercial rent is quoted.)
- Lease expiration dates. If half the rent expires in the next 18 months, you’re not buying stable income. You’re buying a leasing job.
- Lease type. Under a triple net lease, tenants pay their share of taxes, insurance and maintenance. Under a gross lease, you pay them. The same rent number means very different things depending on the lease.
- Renewal options and rent increases. Built-in bumps are good. A tenant’s option to renew at a below-market rate is not.
- Security deposits and any free rent. If a tenant is in a free-rent period, the rent roll may show income you won’t actually collect yet.
Then do the most important check of all: compare the rent roll to the leases. I’ve found rent rolls that listed tenants who had already given notice, rents that didn’t match the lease, and “leased” space that was really a handshake with a relative. The lease is the truth. The rent roll is someone’s summary of it.
How to Read the Operating Statement (T-12)
The operating statement shows money coming in and money going out. Read it in two halves.
Income
Look for three lines:
- Gross potential rent. What the property would earn if every space were leased and every tenant paid on time.
- Expense reimbursements. Money tenants pay back to you for taxes, insurance and common area maintenance (often called CAM).
- Vacancy and credit loss. The rent you don’t collect because space sits empty or a tenant doesn’t pay.
If the vacancy line is zero, be careful. Even a fully leased building loses income over time to turnover, late payers and the months it takes to re-lease a space. I almost always budget for some vacancy, even when the building is full today.
Expenses
Typical operating expenses include property taxes, insurance, repairs and maintenance, CAM costs, utilities the owner pays, landscaping, snow removal, trash and management.
Notice what’s not on that list: mortgage payments, depreciation and big one-time improvements. Those aren’t operating expenses. A good operating statement leaves them out so you can see what the property earns on its own, before financing.
As you read, look at the trend month by month. A sudden drop in repairs in the last few months before a sale can mean the owner stopped maintaining the building to make the numbers look better.
NOI: The Number Everything Hangs On
Net operating income, or NOI, is the single most important number in commercial real estate. It’s simple to figure:
Total income collected − Operating expenses = NOI
NOI is what the property earns before you pay the mortgage. Lenders use it to size your loan. Appraisers use it to set the value. Buyers use it to decide what to pay. Get the NOI wrong and every other number you calculate will be wrong too.
That’s why I never use the seller’s NOI as is. I rebuild it myself, with three adjustments that sellers commonly leave out:
- Vacancy and credit loss. If the seller shows none, I add a realistic allowance for the property type and market.
- Management. Many owners manage their own buildings and leave out a management fee. But your time isn’t free, and a lender will add a fee whether you hire a manager or not.
- Reserves for replacements. Roofs, parking lots and HVAC units wear out. Setting aside a modest amount per square foot each year is the honest way to account for that.
I also check whether the property taxes will go up after the sale. In many areas, a sale triggers a reassessment based on the new price. Call the county assessor’s office and ask how it works where the property is located.
The NOI you’re left with after these adjustments is the one you can trust. It’s the one I use for everything that follows. And once you own the building, NOI is also the number you work to grow. Here are 10 ways to increase your commercial property value by raising it.
Cap Rate: Connecting Income to Price
The capitalization rate, or cap rate, ties a property’s income to its price:
NOI ÷ Price = Cap rate
If a building has an NOI of $100,000 and sells for $1,250,000, the cap rate is 8%. Think of it as the return you’d earn if you paid all cash.
You can flip the formula around to estimate value:
NOI ÷ Market cap rate = Value
This is where small changes add up fast. At an 8% cap rate, every $1 of NOI is worth $12.50 in value. So a seller who overstates NOI by $10,000 is asking you to overpay by $125,000.
A few things to keep in mind:
- A cap rate is only as good as the NOI behind it. An 8% cap on the seller’s numbers might be a 6% cap on the real ones.
- Compare cap rates on similar properties. A grocery-anchored shopping center, a small office building and a self-storage facility in the same town will all trade at different cap rates.
- Ask your broker or appraiser what similar properties have actually sold for, not what they were listed at.
Cap rate is one way to value a property. I cover the other two methods in my post on three ways to value a commercial property.
Cash Flow, DSCR and Cash-on-Cash Return
Cap rate tells you about the property. These three numbers tell you about the deal, once your loan is in the picture.
Cash flow
NOI − Annual loan payments = Cash flow before taxes
This is the money left over for you each year. If it’s thin or negative, the property is depending on you instead of the other way around.
Debt service coverage ratio (DSCR)
NOI ÷ Annual loan payments = DSCR
This is the number your lender cares about most. A DSCR of 1.25 means the property earns $1.25 for every $1.00 of loan payments. Many lenders want to see at least 1.20 to 1.25, and sometimes more for riskier property types. Below 1.0, the building doesn’t earn enough to pay its own mortgage. You can read more about what lenders look for and in my complete guide to financing.
Cash-on-cash return
Annual cash flow ÷ Total cash you put in = Cash-on-cash return
“Total cash you put in” means your down payment plus closing costs and any upfront repairs. This is the return on your own money, and it’s the easiest way to compare a property against other places you could invest.
Putting It Together: A Real-World Example
Let’s walk through a deal like many I’ve seen. It’s a 12,000-square-foot retail strip with four tenants, listed at $1,500,000. The broker’s flyer shows an NOI of $120,000, which works out to an 8% cap rate. Here’s the seller’s version next to mine.
| Seller’s numbers | My numbers | |
| Gross potential rent | $150,000 | $150,000 |
| Expense reimbursements from tenants | $25,000 | $25,000 |
| Vacancy and credit loss (7%) | $0 | −$12,250 |
| Total income | $175,000 | $162,750 |
| Property taxes (reassessed after sale) | $22,000 | $26,000 |
| Insurance | $9,000 | $9,000 |
| Repairs, maintenance and CAM | $18,000 | $18,000 |
| Utilities and services | $6,000 | $6,000 |
| Management (4% of income) | $0 | $6,510 |
| Reserves ($0.25 per sq. ft.) | $0 | $3,000 |
| Total expenses | $55,000 | $68,510 |
| NOI | $120,000 | $94,240 |
| Cap rate at $1,500,000 | 8.0% | 6.3% |
Nothing in my version is pessimistic. I added a normal vacancy allowance, a management fee, modest reserves and a tax increase from the sale. That’s all. Yet the NOI dropped by more than $25,000.
Now add the loan. Say you put 25% down and borrow $1,125,000 at 7% over 25 years. Your payments come to about $95,400 a year.
| At the asking price of $1,500,000 | Seller’s numbers | My numbers |
| Annual loan payments | $95,415 | $95,415 |
| Cash flow | $24,585 | −$1,175 |
| DSCR | 1.26 | 0.99 |
| Cash-on-cash return ($405,000 in, including $30,000 closing costs) | 6.1% | −0.3% |
On the seller’s numbers, this looks like a decent deal. On the real numbers, the building doesn’t cover its own mortgage, and a lender would likely turn the loan down or cut the loan amount.
So what is it worth? If similar strips in the area sell at an 8% cap rate, the value is $94,240 ÷ 0.08, or about $1,178,000. That’s more than $300,000 below the asking price. At $1,178,000, with the same loan terms, the DSCR goes back to 1.26 and the cash-on-cash return is about 5.9%.
That’s the number I’d take into making offers, with my rebuilt operating statement to back it up. The seller may not like it, but it’s hard to argue with numbers built from their own records.
The figures in this example are for illustration. Your rates, taxes and expenses will depend on your market and your lender.
Red Flags in a Seller’s Numbers
These are the warning signs I look for every time. None of them automatically kills a deal, but each one deserves a question.
- Pro forma instead of actual. “Pro forma” means projected. If the flyer shows what the property could earn, ask for what it did earn.
- Zero vacancy, no management fee or no reserves. As the example shows, these three alone can move value by hundreds of thousands of dollars.
- Rents well above market. Above-market rent tends to drop at renewal, or the tenant leaves.
- Leases rolling all at once. Several leases expiring in the same year is a big risk, especially in a small building.
- One tenant paying most of the rent. If that tenant leaves, your income goes with it.
- Expenses that seem too low. Compare repair and maintenance costs to similar buildings. Low numbers can mean deferred maintenance you’ll pay for later.
- Numbers that don’t match. If the rent roll, the T-12 and the tax returns tell three different stories, find out why before you go further.
- Owner-paid expenses missing from the statement. Some owners pay certain bills personally. Check the utility bills and service contracts yourself.
Whatever you find, confirm it during your due diligence period, before your deposit is at risk. Skipping that step is one of the common mistakes I see new investors make. If a term on any of these documents is unfamiliar, my glossary explains it in plain English.
If You’re Coming from Residential
If you’ve bought houses or duplexes, you’re used to value coming from comparable sales. The house down the street sold for $300,000, so yours is worth about the same.
Commercial property doesn’t work that way. Its value comes mostly from the income it produces. That’s why reading the numbers matters so much more here. Raise the NOI and you raise the value, no matter what the building next door sold for. Lower it, and the value falls with it.
The skills you already have still help. You know how to screen tenants, estimate repairs and keep a building running. You’re just adding a new way of looking at value. I wrote about this shift in what changes when you move from residential, and I go into it in depth in my book From Residential to Commercial: Making the Leap.
The Bottom Line
You make your money in commercial real estate when you buy, and you buy well by reading the numbers yourself. Get the rent roll, the T-12 and the leases. Rebuild the NOI with vacancy, management and reserves. Then check the cap rate, DSCR and cash-on-cash return on your numbers, not the seller’s.
If you’re buying your first commercial property, my book Buying Your First Commercial Property walks you through this process step by step, from finding the deal to closing it.
Get My Free Deal Analysis Checklist
Want a simple way to make sure you don’t miss anything? My free Deal Analysis Checklist lists the documents to request, the adjustments to make and the numbers to check before you make an offer. Keep it next to you every time you look at a deal.