Why Commercial Real Estate Underwriting Has Become More Sensitive to Financing

The commercial real estate debt market remains active, but available capital does not necessarily mean inexpensive capital. CBRE reported that lending fundamentals remained strong through the second quarter of 2026, with both the number and average size of loans increasing while lenders maintained disciplined loan-to-value levels. Trepp has also reported relatively tight lending and CMBS spreads despite volatility in Treasury yields.

Berkadia noted that agency spreads remained near historically tight levels for much of 2026, helping offset some of the pressure created by higher Treasury yields. Even with tighter spreads, elevated benchmark rates can keep the total cost of borrowing high, which means sponsors need to evaluate financing assumptions as part of the underwriting process from the beginning rather than treating them as a separate step once the property-level analysis is complete.

For sponsors underwriting acquisitions and developments, simply changing the interest rate in one cell of the model does not provide a complete picture. Changes in debt cost can affect proceeds, required equity, projected returns, refinance assumptions, and ultimately the amount a sponsor can afford to pay for an asset.

How Higher Rates Affect Loan Proceeds

One of the most immediate effects of higher rates is on debt sizing. Commercial real estate loans are generally constrained by some combination of loan-to-value ratio, loan-to-cost ratio, debt service coverage ratio, debt yield, and lender-specific underwriting requirements, and the limiting constraint can change as borrowing costs move.

Debt service coverage ratio, or DSCR, is a common example. DSCR measures the relationship between a property's net operating income and its required debt service. When interest expense increases, annual debt service rises, which means a loan that previously satisfied a lender's minimum DSCR may need to be reduced even if the property's operating performance has not changed.

That reduction can materially change the capital stack. A transaction initially underwritten at 65% leverage, for example, may ultimately support a lower loan amount if debt service becomes the binding constraint. The sponsor then has to determine whether to contribute additional equity, negotiate a lower purchase price, introduce another layer of capital, restructure the financing, or reconsider the investment altogether.

For that reason, acquisition underwriting should evaluate both property-level performance and realistic lender constraints from the outset. Understanding how much debt a property can actually support is just as important as determining how much leverage a sponsor would ideally like to use.

How Capital Structure Impacts Deal Returns

The financing option with the lowest quoted interest rate is not always the best structure for a transaction. Sponsors should compare financing alternatives based on total cost, proceeds, amortization, interest-only periods, recourse requirements, prepayment provisions, extension options, reserves, covenants, rate cap requirements, and execution certainty.

A bridge loan may carry a higher cost of capital but provide greater proceeds or flexibility during a transitional business plan, while permanent financing may offer a lower rate but require stronger in-place cash flow. Preferred equity can reduce the amount of common equity required, but it can also materially change the distribution waterfall and sponsor return profile. Each option should therefore be evaluated based on how it affects the overall economics of the transaction rather than on rate alone.

Commercial real estate financial modeling and capital markets execution are most useful when they remain connected throughout the transaction. Financing decisions should feed directly into the acquisition or development model so the sponsor can evaluate how each structure affects cash-on-cash returns, IRR, equity multiple, required equity, refinance proceeds, and downside exposure before selecting a capital structure.

Stress-Testing Financing Assumptions

Relying on one interest rate and one loan amount can create a false sense of certainty, particularly when capital markets are changing quickly. A stronger underwriting process includes multiple financing scenarios so sponsors can evaluate what happens if borrowing costs increase, loan proceeds decline, amortization requirements change, or a lender modifies its structure before closing.

This is especially important for transactions with longer diligence periods, development timelines, lease-up periods, or future refinancing requirements. A development model may need to evaluate changes in construction interest expense, interest reserves, loan draw timing, stabilization, permanent financing proceeds, and exit assumptions. An acquisition model may need to determine whether lower leverage or a higher cost of debt changes the projected return enough to affect the investment decision.

The purpose of scenario analysis is not to predict exactly where interest rates are headed. It is to understand how resilient the transaction is if financing conditions move differently than originally expected and identify which assumptions have the greatest impact on returns.

Evaluating Exit Assumptions in a Higher-Rate Market

Higher borrowing costs can place pressure on property valuations, but sponsors should avoid assuming that capitalization rates will move mechanically with Treasury yields. Property values are influenced by a broader set of factors, including asset quality, location, rent growth, supply, tenant demand, capital availability, investor appetite, and expectations for future income.

CBRE's 2026 midyear outlook illustrates that complexity. Despite higher long-term rates, the firm continued to forecast approximately 16% year-over-year growth in U.S. commercial real estate investment volume to roughly $605 billion while expecting cap rates to remain largely stable for the remainder of the year. That outlook reinforces the importance of evaluating financing assumptions and property valuation assumptions separately rather than assuming one will automatically move in tandem with the other.

For underwriting purposes, a disciplined model should evaluate whether the investment still works under slower NOI growth, a higher exit cap rate, higher financing costs, a longer hold period, or a combination of those assumptions. The more dependent a transaction is on aggressive rent growth or cap rate compression to achieve its targeted return, the more sensitive it may be to changes in market conditions.

What Sponsors Should Focus on in the Current Market

The current environment puts greater emphasis on disciplined assumptions and scenario analysis. Sponsors should understand what drives the investment return, how much leverage the property can realistically support, how the transaction performs under different financing scenarios, and which assumptions create the greatest downside risk.

The objective is not simply to make the underwriting more conservative. A strong commercial real estate underwriting model should function as a decision-making tool that helps sponsors understand how changes in the capital structure or business plan affect the transaction before those changes become problems.

That means the model should be able to answer practical investment questions throughout the deal process. Sponsors should be able to see what happens if a lender reduces proceeds, how much additional equity would be required, whether the investment still meets return requirements if the exit cap rate expands, how a longer stabilization period affects returns, and what happens to refinance proceeds if rates remain elevated.

The same analysis should also help compare competing financing structures. The most attractive capital solution may be the one that provides the right balance of proceeds, cost, flexibility, risk, and execution certainty rather than simply the lowest initial rate.

Connecting Underwriting and Capital Markets

Commercial real estate transactions rarely remain static from initial underwriting through closing. Operating statements change, rent rolls are updated, property tax and insurance assumptions are refined, capital expenditure budgets move, lender quotes arrive, debt proceeds change, and new information emerges during diligence.

Each of those developments can affect projected returns, which is why the financial model should continue evolving throughout the transaction. Maintaining a live model during diligence and capitalization allows sponsors to evaluate new information as it becomes available and understand how changes in financing affect the overall investment case.

It also allows underwriting and capital markets decisions to operate from the same set of assumptions. When live financing terms are incorporated directly into the model, sponsors can compare lender proposals more accurately, understand changes in required equity, evaluate alternative capital structures, and make more informed decisions before committing additional time and capital to a transaction.

In a market where lenders remain active but benchmark rates, proceeds, structure, and execution requirements can shift quickly, the connection between underwriting and capital markets has become increasingly important. Sponsors that evaluate the real estate and financing together are better positioned to understand the full economics of a transaction as it moves from the initial opportunity through closing.

Commercial Real Estate Underwriting Support From Foss

Foss Real Estate Partners works as an embedded extension of real estate sponsors' deal teams, providing commercial real estate underwriting, financial modeling, capital markets execution, asset management, and fund management support. Rather than treating underwriting and financing as isolated workstreams, Foss supports sponsors throughout the transaction so the financial analysis can continue evolving as diligence progresses and the capital structure takes shape.

From the initial opportunity evaluation through diligence, capitalization, closing, and ongoing ownership, Foss provides the financial and capital markets resources needed to evaluate transactions, respond to changing assumptions, and execute efficiently. If your team is evaluating an acquisition, development, refinance, or recapitalization and needs additional underwriting or capital markets support, Foss can work alongside your team from the initial model through closing and ongoing ownership.