The Mistakes Are Predictable

After reviewing hundreds of CRE deal packages, a pattern emerges. The same eight errors show up in amateur underwriting, and every single one inflates projected returns. That is not a coincidence. Seller-side pro formas are built to sell, not to inform. The gap between what the broker shows you and what the property actually delivers is where money disappears.

These are the eight errors, in the order they typically destroy returns.

1. Overlooking Tenant Improvements and Leasing Commissions

When an office or retail tenant moves out, the landlord pays to prepare the space for the next one. These costs are called tenant improvement (TI) allowances, and they range from $15 to $80+ per square foot depending on whether the space was previously occupied or needs a full buildout. On top of that, leasing commissions (LCs) run 2% to 8% of the total lease value.

Broker pro formas almost never include these costs above the NOI line. They show inflated NOI because they treat re-tenanting as if it costs nothing. On a 50,000 SF office building with a $30/SF TI allowance and 5% leasing commission, you are looking at $1.5 million in TI costs plus another $300K to $500K in commissions over a typical lease cycle.

What it costs: On a 50,000 SF office building, a single lease cycle with $30/SF TI and 5% LC on a $20/SF, 7-year lease can run $1.5M in TI plus $350K in commissions. Spread over the lease term, that is $265K per year that the pro forma pretends does not exist. On a deal with $600K in stated NOI, that is 44% of your cash flow.

The red flag: any office or retail deal where the pro forma shows no TI/LC line item. It does not mean the costs don't exist. It means they were hidden.

2. Gaming DSCR with Interest-Only Periods

Bridge loans and transitional financing often include an interest-only (IO) period for the first 2 to 3 years. During IO, there is no principal payment, so the DSCR looks great. The deal "pencils." The lender is happy. Everyone celebrates.

Then the IO period expires. Principal payments begin. The annual debt service jumps 30% to 50%, and the DSCR that was comfortably at 1.40x drops to 1.05x or below.

What it costs: Take a $5M loan at 7% interest-only. Annual debt service: $350K. With $500K NOI, your IO-period DSCR is 1.43x. Comfortable. Now the IO burns off and amortization begins on a 30-year schedule. Annual debt service jumps to $399K. DSCR drops to 1.25x. Tight but passable. Now add the +150 bps refinance stress: debt service at 8.5% amortizing is $461K. Stressed DSCR: 1.08x. Below most lender thresholds. The deal that "penciled" at signing fails at refinance.

Institutional underwriters calculate three DSCRs: going-in (current), stabilized (after business plan execution), and stressed (at +150 basis points, per the Federal Reserve's DFAST methodology). If any of these three falls below the lender threshold, the deal has refinancing risk. Running only the IO-period DSCR is not underwriting. It is marketing.

3. Inconsistent Capital Reserve Treatment

Capital reserves sit in a gray zone between NOI and cash flow. Some operators treat them above the line (reducing NOI). Others treat them below the line (reducing cash flow but preserving a higher stated NOI). Both are valid conventions. The problem is comparing deals that use different treatments.

A deal showing 7.5% cap rate with reserves above the line and another showing 7.5% with reserves below the line are not equivalent. The second deal has a higher stated NOI because $250 to $350 per unit in reserves are excluded. This makes cap rate comparisons across deals meaningless unless you normalize the treatment.

What it costs: On a 200-unit multifamily deal, $300/unit/year in reserves is $60K. If one deal includes that in NOI and another excludes it, the stated cap rates differ by roughly 30 to 40 basis points on a $1M NOI property. That is enough to change your purchase price by $400K to $600K if you are using the wrong comparable.

The red flag: no disclosure of how reserves are handled. If you cannot tell whether reserves are above or below the NOI line, the cap rate is unreliable.

4. Trusting the Pro Forma Over the T-12

The trailing 12-month (T-12) operating statement shows what the property actually earned. The pro forma shows what the seller hopes it will earn. Guess which one the broker hands you first.

Pro forma rents assume stabilized occupancy, market-rate renewals, and executed rent bumps. T-12 rents show the reality: current vacancies, concessions given to retain tenants, bad debt, and expenses that actually hit.

NCREIF institutional data shows that NOI growth runs approximately 200 basis points below inflation for aging buildings. When a broker projects rent growth at or above inflation for a 15-year-old property without a major renovation, they are projecting growth that contradicts 25+ years of institutional data. The red flag: pro forma rents materially above in-place rents without documented lease-up support or a credible value-add plan.

5. Ignoring Property Tax Reassessment

This is the single most expensive mistake in first-time CRE acquisitions, and it is the simplest to avoid.

In most jurisdictions, a property sale triggers reassessment of the property's taxable value to the purchase price. If the seller bought the property 10 years ago for $3 million and you are buying it for $8 million, the tax bill is about to reflect an $8 million assessment. In markets like Texas, where effective property tax rates run 2% to 3%, this can add $100,000 to $150,000 in annual expense that the broker's pro forma does not show.

The broker's pro forma uses the seller's current (low) tax basis. Your actual tax bill will be based on your purchase price. The difference can reduce NOI by 5% to 15% on a single line item.

The fix is straightforward: multiply your purchase price by the local effective tax rate. If the result is materially higher than the pro forma property tax line, adjust NOI accordingly. Then recalculate cap rate, DSCR, and debt yield with the corrected number.

6. Insurance Understatement in Climate-Exposed Markets

Between 2022 and 2026, insurance premiums in climate-exposed markets increased 200% to 500%. Florida, the Gulf Coast, California wildfire zones, and the coastal Southeast have seen the sharpest increases. Carriers have left markets entirely. Coverage that cost $50,000 in 2021 now costs $150,000 to $250,000.

Broker pro formas typically use historical insurance costs from before this repricing. If you underwrite a coastal Florida multifamily deal using the 2020 insurance premium, your NOI is overstated by $100K+ and your DSCR may fail when you source an actual current quote.

The red flag: insurance expense below 0.3% of property value in any market with hurricane, flood, or wildfire exposure. If the pro forma insurance line looks suspiciously low, get a current insurance quote before you underwrite the deal.

7. No Interest Rate Stress Test

Running a deal at today's interest rates and calling it done is the single most common cause of CRE distress. NBER research found that 14% of all CRE loans were in negative equity by 2023 after the rate hikes that began in 2022. For office properties, 44%.

A deal that works at 6.5% may not work at 8.0%. The Federal Reserve's DFAST stress testing framework applies a +150 basis point rate increase as the standard adverse scenario. If your DSCR drops below 1.0x under that stress, you cannot safely refinance. And since most CRE loans mature in 5 to 10 years, you will refinance.

The math is not complicated. Take your loan amount. Calculate debt service at current rate + 150 basis points. Divide your NOI by that stressed debt service. If the result is below 1.0x, the deal has a structural problem that no amount of optimism will fix.

8. Assuming a Flat Exit Cap Rate

Every IRR projection has two big assumptions: operating cash flows during the hold, and the sale price at exit. The sale price is determined by the exit cap rate. And here is where optimism turns into money lost.

Underwriting exit at the same cap rate as entry, or lower, is implicitly betting that cap rates will compress during your hold period. That is a market bet, not an operating bet. And cap rate compression is not a strategy.

Terminal value (the exit sale) typically represents 60% to 75% of total value in a 10-year DCF model. A 50 basis point change in exit cap rate can move your projected IRR by 300 to 600 basis points. A deal projecting 15% IRR with a 5.5% exit cap might deliver 9% at a 6.0% exit cap.

The institutional standard: underwrite exit cap rate at 25 to 50 basis points higher than going-in cap rate. If the current spread to 10-year Treasury is already compressed (below 150 basis points), cap expansion is more likely than compression. Your exit assumption should reflect that.

The Cumulative Impact

Here is what happens when multiple errors stack on a single deal. Take a $10M multifamily acquisition at a broker-stated 7% cap rate ($700K NOI):

Error NOI/Return Impact
Property tax reassessment -$80K NOI
Insurance understatement -$60K NOI
No CapEx reserves ($300/unit x 150 units) -$45K cash flow
Rent growth at inflation vs. reality (-200 bps) -$30K NOI by Year 3
Corrected NOI $530K (not $700K)
Corrected cap rate 5.3% (not 7.0%)

The broker's 7% cap becomes 5.3% once you correct four line items. The deal that looked like a strong buy is now below the 10-year Treasury spread threshold. The IRR that projected 14% might deliver 7%.

All eight mistakes point in the same direction: they make deals look better than they are. Broker pro formas omit costs (TI/LC, reassessed taxes, current insurance). Amateur underwriting ignores stress scenarios (rate increases, IO expiration, cap expansion). The result is projected returns that exist on paper but not in reality.

The Mental Model: The Seller's Pro Forma Is a Marketing Document

There is one framework that protects you from all eight errors at once: treat every seller pro forma as a marketing document until you have independently verified every line.

This is not cynicism. It is how institutional buyers operate. The acquisition team re-builds the pro forma from scratch using T-12 actuals, current insurance quotes, reassessed taxes, and empirically-grounded growth rates. They never start from the broker's version and adjust. They start from zero and build up.

If your corrected NOI is within 5% of the broker's number, you probably have a real deal. If the gap is 15% or more, one of two things is true: you found errors the broker missed, or the deal is priced to sell, not priced to buy. Either way, you now have the leverage to negotiate or walk away with confidence.

Every one of these errors is detectable in the first 60 seconds of analysis if you know what to look for.

Go Deeper

Each of these errors maps to a full article on this site:

Sources

  • Geltner et al., "Commercial Real Estate Analysis and Investments," 2nd Ed. (2007), Chapters 11, 13, 18
  • NBER Working Paper 31970, "Monetary Tightening, Commercial Real Estate Distress, and US Bank Fragility" (2023)
  • Federal Reserve DFAST stress testing methodology
  • NCREIF Property Index, 1978-2004 (NOI growth and CapEx data)
  • Esaki et al., "Commercial Mortgage Defaults: An Update" (2002)