In this guide
- What underwriting means
- NOI: the foundation metric
- Cap rate: definition and formula
- What's a "good" cap rate
- What cap rate can't tell you
- DSCR: what lenders actually check
- IRR: the number that includes everything else
- One property, underwritten end to end
- Common underwriting mistakes
- Underwriting a 1031 replacement property
- Frequently asked questions
What underwriting means
Underwriting is the process of testing whether a property's price is justified by what it actually earns, and whether it can support the debt used to buy it — the discipline that separates an investment decision from a pitch-deck decision. Every commercial deal, from a $2 million net-lease property to a $200 million multifamily portfolio, gets evaluated through the same four numbers in sequence: NOI establishes what the property earns; cap rate checks that earnings against price; DSCR checks that earnings against debt; and IRR projects what an investor actually nets once financing, time, and an exit are added. Skipping any one of them means trusting someone else's math.
NOI: the foundation metric
Net operating income is a property's income after operating expenses but before debt service, capital expenditures, and income taxes:
NOI = Gross Rental Income + Other Income − Vacancy − Operating Expenses
Operating expenses include property taxes, insurance, management fees, repairs and maintenance, utilities (to the extent not passed through to tenants), and reserves for turnover — but never mortgage payments, depreciation, or capital improvements, which sit below NOI in the analysis. Every other number in this guide is downstream of NOI; an inflated or optimistic NOI (understated vacancy, expenses left off, one-time income included as recurring) corrupts the cap rate, the DSCR, and the IRR that follow, which is why a serious buyer rebuilds the seller's NOI from the actual trailing operating statements and rent roll rather than accepting the offering memorandum's number as given.
Cap rate: definition and formula
Cap Rate = NOI ÷ Purchase Price (or Current Value)
Cap rate answers one question: what percentage return does this property's income represent on its price, with no debt in the picture at all? A property with $150,000 NOI purchased for $2,500,000 has a 6% cap rate. It's the fastest way to compare two properties' pricing on an apples-to-apples, all-cash basis, and it's the metric brokers lead with because it's the simplest to state. It is also, on its own, an incomplete answer to "is this a good deal" — see below.
What's a "good" cap rate
| Property type / market | Typical 2026 cap rate range |
|---|---|
| Stabilized multifamily, primary market | 4.5-5.5% |
| Grocery-anchored retail, industrial (credit tenant) | 5.5-6.5% |
| Office, well-located, credit tenant | 6.5-8% |
| Secondary/tertiary market, older assets, shorter leases | 6.5-8.5%+ |
| Value-add / distressed / significant lease rollover | 8%+ |
A lower cap rate reflects a market paying a premium for perceived safety, growth, or liquidity (primary-market multifamily, credit-tenant net lease); a higher cap rate reflects a market demanding more compensation for risk (secondary markets, shorter leases, older buildings, uncertain renewal). Neither is universally "good" — the question is always whether the rate matches the asset's actual risk. A cap rate meaningfully below the market range for that property type is often the clearest early sign of an underwriting problem, not a great find.
What cap rate can't tell you
Cap rate is a snapshot, not a return: it says nothing about financing (an investor's actual return depends heavily on leverage — see IRR below), nothing about future rent growth or expense inflation, and nothing about capital needs the property will require during the hold. Two properties can carry an identical 6% cap rate and be entirely different investments — one with a long-term credit tenant and no near-term capex, the other with a lease expiring in 18 months and a roof at the end of its life. This is also where two rough consumer rules of thumb sometimes surface in commercial conversations and shouldn't be trusted there: the 1% rule and 2% rule (monthly rent as a percentage of price) are quick screens built for small residential rentals, not institutional underwriting standards — most sound stabilized commercial deals fail them comfortably.
DSCR: what lenders actually check
DSCR = NOI ÷ Annual Debt Service
Debt service coverage ratio measures how many times over a property's NOI covers its annual mortgage payments (principal and interest). A DSCR of 1.25x means NOI exceeds the annual debt payment by 25% — the cushion a lender wants before a bad month, a vacancy, or an unexpected repair threatens the ability to pay the mortgage.
| Lender / product type | Typical minimum DSCR |
|---|---|
| Agency multifamily (Fannie Mae, Freddie Mac), strong assets | 1.20-1.25x |
| Conventional bank commercial loan | 1.25x |
| Bridge / value-add debt | 1.10-1.20x (interest-only structuring common) |
| Higher-risk property types (hospitality, heavy value-add) | 1.30x+ |
| DSCR loan products (small investment/multifamily property, income-only qualification) | Often 1.00-1.25x, paired with 20-25% down |
DSCR also determines the maximum loan amount a property can support — lenders size the loan to the DSCR floor, not just a loan-to-value ceiling, so a property with strong NOI can sometimes borrow more than LTV alone would suggest, and a property with thin NOI gets capped well below what LTV would otherwise allow. Worth distinguishing: DSCR as a ratio applies to every commercial loan; a "DSCR loan" is a specific loan product, mostly for one-to-four-unit and small multifamily investment property, that qualifies the borrower on the property's own cash flow rather than personal income documentation — useful for investors whose income doesn't fit a W-2 profile, at the cost of a higher rate than a fully-documented conventional loan.
IRR: the number that includes everything else
Internal rate of return is the annualized return that accounts for every cash flow over the entire hold — the initial investment, every year's distributions, and the sale proceeds — discounted for timing. Unlike cap rate, IRR captures financing (leverage can raise IRR well above the unlevered cap rate, or destroy it if debt is too expensive or too large), rent growth, expense inflation, and the exit assumption. It's the number a sponsor's targeted return actually is, and it's also the easiest number to inflate quietly: an aggressive exit-cap-rate assumption (assuming the property sells for a lower cap rate — a higher price — than it was bought at) can turn a mediocre deal into an impressive-looking IRR on paper. The single highest-value diligence habit for any offering: rebuild the IRR with a flat or slightly higher exit cap rate than the entry rate, and see what survives.
One property, underwritten end to end
A 60-unit apartment property, offered at $9,000,000:
| Step | Calculation | Result |
|---|---|---|
| Gross potential rent | 60 units × $1,400/mo × 12 | $1,008,000 |
| Less vacancy (5%) | − $50,400 | $957,600 |
| Plus other income (parking, fees) | + $36,000 | $993,600 effective gross income |
| Less operating expenses (42% of EGI) | − $417,312 | NOI: $576,288 |
| Cap rate at asking price | $576,288 ÷ $9,000,000 | 6.4% |
| Debt sized at 65% LTV, 6.5% rate, 30-yr amortization | $5,850,000 loan, ~$443,500 annual debt service | |
| DSCR at that loan amount | $576,288 ÷ $443,500 | 1.30x — clears a typical 1.25x minimum |
| Year-1 cash flow to equity | NOI − debt service | $132,788 on $3,150,000 equity — 4.2% cash-on-cash |
| 5-year IRR (3% annual rent growth, exit at 6.6% cap — 20bps higher than entry) | Modeled across all 5 years' cash flow plus net sale proceeds | ~13-15% (illustrative range; sponsor models vary by assumption) |
Notice what moved the outcome: a conservative exit-cap assumption (higher, not lower, than entry) kept the IRR believable; the DSCR check confirmed the debt was financeable before the equity math mattered at all; and the cap rate alone — 6.4% — said nothing about the leveraged return until debt and time were added. This is the sequence every serious underwriting exercise follows, whether it's a $9 million apartment deal or a property being evaluated as a 1031 replacement under a 45-day clock.
Common underwriting mistakes
Accepting the seller's or sponsor's NOI without rebuilding it from trailing financials and the actual rent roll; using an exit cap rate lower than the entry cap rate to manufacture IRR; underestimating capex and reserves, especially on older properties; ignoring near-term lease rollover in the income projection; sizing debt to a lender's best-case DSCR quote rather than a stressed scenario; and treating a headline "targeted IRR" as a promise rather than a projection built on assumptions that deserve to be questioned individually.
Underwriting a 1031 replacement property
Every deadline pressure of a 1031 exchange makes underwriting more important, not less — a rushed identification inside the 45-day window is exactly when a seller's optimistic NOI or an inflated cap rate is most likely to go unchecked. The same four numbers apply whether the replacement is a direct property, a net-lease asset, or the property inside a DST — a sponsor's offering memorandum is, functionally, someone else's underwriting handed to you, and worth rebuilding rather than trusting on a clock. Deferral math for the exchange itself: 1031 Exchange Calculator.