A 12% projected internal rate of return can look attractive on paper. But what if one property has a financially strong tenant with eight years remaining on the lease, while another has an uncertain tenant, a lease expiring in 18 months, significant deferred maintenance, and a loan approaching maturity?
Would you consider them equally attractive investments? I hardly would.
Commercial real estate investors often compare opportunities using internal rate of return (IRR), capitalization rate (cap rate), cash-on-cash return, and projected appreciation. These are valuable financial measurements. But numbers alone tell only half the story.
Every commercial property has its own characteristics, strengths, weaknesses, risks, and opportunities. Two buildings on the same street, with identical square footage and projected returns, can produce very different investment outcomes.
The distinction is between projected return and risk-adjusted return.
Projected return estimates what an investment may earn under a particular set of assumptions.
Risk-adjusted return considers whether that potential return adequately compensates the investor for the uncertainty, potential losses, and capital exposure required to achieve it.
Understanding this distinction is essential for investors evaluating industrial, warehouse, office, R&D, flex, retail, and other commercial properties in Fremont, Silicon Valley, and the Greater San Francisco Bay Area.
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In our earlier two-part series on commercial real estate pro forma analysis, I explained why a pro forma should serve as a dynamic financial framework that evolves with the property, market conditions, and investment objectives.
In Part 1, I explained: “A spreadsheet can calculate a cap rate, internal rate of return, cash-on-cash return, or projected future value.” But the more difficult task is identifying the appropriate assumptions behind those calculations.
Read Commercial Real Estate Pro Forma: A Framework for Investment Decisions — Part 1.
In Part 2, we discussed how a pro forma should evolve as ownership conditions change, helping investors decide whether to hold, refinance, reposition, sell, or complete a 1031 Exchange.
Read Commercial Real Estate Pro Forma: A Dynamic Framework for Investment Decision-Making — Part 2.
Now we need to go one step further.
A pro forma may indicate that a property could generate a 12% IRR over five years. But what is the probability that the projected cash flows will actually materialize? What happens if the tenant leaves, or terminates the lease early? What if the building requires unexpected improvements? What if the lender refuses to refinance, or requires additional capital to satisfy the debt coverage ratio? What if the investor cannot sell the property at the projected exit value?
Answering these questions requires understanding the investment risks behind the numbers. A sophisticated investor should understand both the potential return and the risks required to achieve it.
In our earlier article, Internal Rate of Return (IRR) in Commercial Real Estate Investment, we explained IRR by asking:
“Given all of the cash in and cash out over my entire hold period, including my eventual sale, what is my annualized return on this deal?”
IRR is the discount rate at which the net present value of an investment’s cash flows equals zero.
In commercial real estate, a projected IRR may incorporate the initial investment, rental income, operating expenses, capital expenditures, and proceeds from a future sale.
A leveraged equity IRR also reflects financing costs, loan payments, and the outstanding loan balance at sale.
The calculation is valuable because it considers both the amount and timing of cash flows.
But there is an important limitation.
IRR tells you the return implied by the assumptions. It does not tell you whether those assumptions will occur.
For example, a five-year projection might assume:
If those assumptions materialize, the projected return may be achievable.
But if even two or three assumptions prove inaccurate, the actual return could be substantially different.
Not necessarily.
The phrase “risk-adjusted IRR” is often used broadly in commercial real estate investment discussions. Unlike conventional IRR, it does not refer to one universally accepted formula.
Investors may assess risk through probability-weighted scenarios, required return premiums, sensitivity analysis, downside cash-flow projections, or other quantitative and qualitative methods.
For example, an investor could develop several possible cash-flow scenarios, assign probabilities to each scenario, calculate the probability-weighted cash flows for each period, and then estimate the IRR from those expected cash flows. This approach produces an IRR based on expected cash flows, but it does not, by itself, establish a fully risk-adjusted return.
Another approach is to increase the investor’s required return to reflect additional risk.
These methods answer related but different questions.
A probability-weighted expected return and an investor’s required return serve different purposes. The former estimates potential investment performance based on assigned probabilities, while the latter reflects the minimum return an investor requires for assuming the investment’s risks.
For this article, I use risk-adjusted return in its practical investment sense: evaluating projected returns in light of the likelihood, severity, and consequences of potential adverse outcomes.
The key is to avoid treating a projected IRR as though it were a guaranteed return.
Consider two hypothetical commercial properties in the Silicon Valley market.
Both are offered at $5 million. Both have a projected five-year, leveraged equity IRR of 12% under respective base-case assumptions.
Yet the underlying investment risks are materially different.
| Investment Factor | Property A | Property B |
|---|---|---|
| Purchase price | $5 million | $5 million |
| Projected five-year equity IRR | 12% | 12% |
| Tenant financial strength | Established, financially strong company | Smaller company with uncertain financial capacity |
| Remaining lease term | 8 years | 18 months |
| Building condition | Well-maintained, limited near-term capital needs | Aging improvements and potential major repairs |
| Location | Established industrial submarket with broad tenant demand | More limited tenant pool |
| Financing | Longer-term fixed-rate financing assumed | Loan maturity or refinancing exposure during hold |
| Exit assumptions | Supported by conservative leasing and resale assumptions | Dependent on successful re-leasing and favorable resale pricing |
Please note that this is an illustrative comparison only. The projected IRRs are assumed rather than derived from actual transaction cash flows. These are not representations of properties sold or advised on by The Ivy Group. The two properties are assumed to achieve the same projected IRR through different combinations of income, expenses, financing, and exit assumptions.
At first glance, the two properties appear to offer the same projected financial return.
But consider what happens if the tenant in Property B vacates after 18 months.
The owner may face several months of lost rent, leasing commissions, rent concessions, tenant improvement expenses, operating costs during vacancy, and possibly additional debt-service obligations.
If the property also requires a new roof, parking lot repairs, or major HVAC replacement, the financial impact could increase significantly.
Meanwhile, Property A may continue generating rental income with fewer immediate leasing or capital requirements.
Does this mean Property A is automatically the better investment? Not necessarily.
Property B might offer significant upside through below-market rents, redevelopment potential, or the opportunity to acquire the property at a meaningful discount to its underlying market value.
Investors considering Property B should evaluate whether the potential upside, purchase price, available reserves, and other protections adequately compensate them for its additional risks.
The fundamental mistake is assuming two properties with identical projected IRRs necessarily offer equivalent investment value.
Rental income is only as reliable as the tenant’s ability and willingness to meet its lease obligations.
A building occupied by an established company with strong financial resources may have a different risk profile from one occupied by a young company that is consuming cash and depends on continued outside funding.
Investors should evaluate:
A strong tenant does not eliminate risk, and a smaller tenant is not automatically a weak tenant. Evaluating each tenant’s financial capacity remains essential when assessing the reliability of projected rental income.
For a single-tenant building, this concern becomes especially important because one default or vacancy can eliminate the entire rental revenue stream.
Lease rollover refers to the expiration of existing leases and the uncertainty surrounding renewals or replacement tenants.
Consider two industrial buildings with identical current net operating income (NOI).
One has eight years remaining on its lease.
The other has a lease expiring in 12 months.
The second property may face an immediate challenge: Will the tenant renew? At what rental rate? Will the landlord need to provide free rent, tenant improvements, or other concessions? How long might the space remain vacant if the tenant vacates?
Even a financially strong tenant may relocate because of expansion, consolidation, changes in its supply chain, or shifting operational requirements.
An investor must therefore consider the rent being collected today and also the probability and cost of maintaining that property over time.
A property with an attractive purchase price may become substantially more expensive once the owner accounts for future capital needs.
Examples include:
In Fremont and Silicon Valley’s industrial and R&D markets, electrical capacity, loading configuration, building infrastructure, and permitted uses can strongly influence tenant demand.
A building purchased at a discount may require substantial capital to compete with newer, modern facilities.
Conversely, an older property with functional improvements already completed may provide more predictable cash flow than a seemingly comparable building with deferred maintenance.
Investors should evaluate the total costs across a property’s entire life cycle, including acquiring, owning, operating, improving, leasing, financing, and eventually selling the property.
Fremont, Newark, Hayward, Milpitas, Santa Clara, and San Jose are interconnected commercial real estate markets, but they are different submarkets.
Even within Fremont, an industrial building in the Warm Springs Innovation District may have different tenant demand, infrastructure characteristics, transportation advantages, zoning, and redevelopment potential from a property in the northern part of the city.
For a manufacturing tenant, sufficient electrical capacity to operate industrial machinery, loading access, permitted industrial uses, workforce availability, and proximity to transportation nodes and suppliers may determine whether a building is suitable.
For an office or R&D tenant, transportation access, amenities, laboratory capabilities, and proximity to specialized technical talent may be more important.
These physical and market characteristics affect future rental demand, vacancy exposure, required improvements, and resale liquidity.
A pro forma that applies a generic market rent or vacancy assumption without understanding the individual property can produce misleading results.
Leverage can increase investment returns, but it can also magnify losses.
Financing risk includes:
A property might generate sufficient cash flow under its original loan but become financially strained when refinancing at a higher interest rate.
A projected leveraged IRR may therefore appear attractive while concealing significant exposure to refinancing conditions.
Investors should compare unleveraged property performance with leveraged equity returns to understand how financing affects potential returns, cash flow, and downside exposure.
This is one of the most overlooked risks in commercial real estate underwriting.
A five-year pro forma may project healthy rental income, but much of its total return may depend on selling the building at a particular price in Year 5.
That future value is often estimated using the property’s anticipated NOI divided by an assumed exit capitalization rate.
Consider a hypothetical building generating $300,000 in annual NOI at the time of sale.
| Assumed Exit Cap Rate | Estimated Gross Property Value |
| 5.0% | $6,000,000 |
| 5.5% | $5,454,545 |
| 6.0% | $5,000,000 |
| 6.5% | $4,615,385 |
Please note that this is an illustrative valuation only. Figures exclude selling costs, debt payoff, taxes, and other adjustments.
A change from a 5.0% exit cap rate to a 6.0% exit cap rate reduces the estimated property value from $6 million to $5 million.
That is a $1 million difference, even though the assumed NOI remains unchanged.
For an investor who financed the acquisition with borrowed money, the impact on the investor’s equity could be even greater. After paying off the outstanding loan balance and selling expenses such as commissions, the investor may receive substantially less equity from the sale, potentially reducing the projected IRR.
When I review a commercial real estate investment, I want to understand how much of the projected IRR depends on the property’s future sale price rather than the cash flow generated during ownership.
If the investment only works under an optimistic exit cap rate, that should be a warning sign.
Coming up in Part 2, we will explore how investors can evaluate risk through base, upside, and downside scenarios. We will also illustrate risk-informed investment decision-making through two real-world case studies from The Ivy Group.
Stay tuned.
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The Ivy Group specializes in commercial sales, leasing, and investment advisory across Fremont, Silicon Valley, and the Greater Bay Area. With over 100 years of combined experience and professional designations including SIOR, CCIM and CIPS (Society of Industrial and Office Realtors®, Certified Commercial Investment Member, Certified International Property Specialist), The Ivy Group provides strategic guidance for complex commercial real estate transactions.
The team’s investor and developer perspective brings firsthand ownership experience to the advice we provide. When you need to sell, buy, lease, or evaluate a commercial real estate investment, The Ivy Group is ready to help you reach your goals.
Disclaimer: All information shared in this article, and in all blogs, case studies, and courses offered by The Ivy Group, is for general educational purposes only and does not constitute tax, legal, accounting, or investment advice. Investment projections, hypothetical scenarios, and illustrative returns are not guarantees of future performance. Please consult qualified tax, accounting, legal, financial, and other professional advisors before making investment decisions.
Copyright © 2026 by Tim Vi Tran, SIOR, CCIM, CIPS. All rights reserved.
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