Multifamily Underwriting Basics: NOI, Cap Rate and DSCR
Underwriting a multifamily deal means building a financial model of the property to test whether its income can support the price, the loan and the investors' return. The core measures are net operating income (NOI), the cap rate, the debt service coverage ratio (DSCR) and break-even occupancy.
If you are the sponsor raising equity for an apartment deal, we built DoorRaise for the raise, and good underwriting is what you bring to it. For where underwriting sits in the bigger picture, see our guide to real estate syndication.
What are the building blocks of multifamily underwriting?
The building blocks are a short list of income lines, an expense total and four ratios built from them. Learn these six terms and you can read most sponsor models.
| Term | Formula | What it tells you |
|---|---|---|
| Gross potential rent (GPR) | Units x market rent x 12 | Income if every unit were leased |
| Effective gross income (EGI) | GPR - vacancy and credit loss + other income | Income you actually expect |
| NOI | EGI - operating expenses | Property income before debt and income tax |
| Cap rate | NOI / purchase price | Yield on the property alone |
| DSCR | NOI / annual debt service | Cushion over loan payments |
| Break-even occupancy | (Operating expenses + debt service) / GPR | Occupancy needed to cover costs |
What belongs in operating expenses
Operating expenses include property taxes, insurance, utilities, payroll, repairs and maintenance, management fees and a reserve for replacements. They do not include loan principal or interest, depreciation or income taxes. That is why NOI measures the property, not the investor's tax result. Investors receive taxable results on a Schedule K-1, and IRS K-1 instructions show that a partner's share of net rental real estate income or loss is reported on its own line (Box 2). That figure reflects tax items such as depreciation, so it will not match NOI. Ask your CPA how it is calculated.
Why management fees and reserves are not optional
A model that leaves out a management fee because the sponsor manages it, or leaves out replacement reserves because nothing has broken yet, overstates NOI. Lenders and buyers will add those costs back, and so should you.
A worked example: NOI, cap rate, DSCR
The example below is illustrative. The numbers are made up to show the math and are not a market benchmark or a projection. It uses a 100-unit property bought for $10,000,000.
| Line | Amount |
|---|---|
| Gross potential rent (100 units x $1,200 x 12) | $1,440,000 |
| Vacancy and credit loss (8%) | -$115,200 |
| Other income (parking, laundry, fees) | $75,200 |
| Effective gross income | $1,400,000 |
| Operating expenses | -$700,000 |
| NOI | $700,000 |
| Cap rate ($700,000 / $10,000,000) | 7.0% |
Say the loan is $7,000,000, which is 70% of price, at 7.5% interest only. Annual debt service is $525,000.
| Measure | Calculation | Result |
|---|---|---|
| DSCR | $700,000 / $525,000 | 1.33x |
| Break-even occupancy | ($700,000 + $525,000) / $1,440,000 | 85.1% |
The property can lose about 15 points of occupancy from full before it stops covering expenses and debt. A DSCR of 1.0x means NOI exactly covers the loan payment, so lenders require a cushion above it. Fannie Mae's conventional multifamily term sheet lists a minimum DSCR of 1.25x for that program, and other lenders and loan types differ. Ask the sponsor what the loan actually requires.
How do you stress-test a deal?
A stress test changes one or two inputs to see how far the numbers move. The base case is where the sponsor hopes to be. The stress case shows what happens when the market does not cooperate.
Using the same property and the same $525,000 of debt service, here are five scenarios. Other income is held at $75,200, and every result is computed from the formulas above.
| Scenario | EGI | NOI | DSCR | Break-even occupancy |
|---|---|---|---|---|
| Base case (8% vacancy) | $1,400,000 | $700,000 | 1.33x | 85.1% |
| Rents 3% lower | $1,360,256 | $660,256 | 1.26x | 87.7% |
| Expenses 10% higher | $1,400,000 | $630,000 | 1.20x | 89.9% |
| Vacancy at 12% | $1,342,400 | $642,400 | 1.22x | 85.1% |
| All three together | $1,304,384 | $534,384 | 1.02x | 92.7% |
Each single change leaves the property above 1.0x, though two of them (1.20x and 1.22x) fall under the 1.25x minimum noted above. All three together leave almost no cushion: NOI covers the loan by just 2%. If the value is set by NOI at a 7.0% cap rate, NOI of $534,384 implies a value of about $7,634,000, below the $10,000,000 price and above the $7,000,000 loan. That is a thin margin for the equity.
Break-even occupancy does not change with vacancy because it is measured against potential rent. The vacancy row changes NOI and DSCR but not that ratio.
Why does the exit cap rate matter so much?
The exit cap rate matters because sponsors often project a sale price by dividing a future NOI by an assumed exit cap rate, and small changes in that rate move value a lot. A projected return can depend more on the exit assumption than on the operating plan.
Using the same illustrative numbers, suppose NOI grows to $800,000 by sale. At a 7.0% exit cap rate, the value is about $11,429,000. At 7.5%, it is about $10,667,000. At 8.5%, it is about $9,412,000. The same NOI is worth about $2,000,000 less across that range.
Conservative sponsors often assume an exit cap rate at or above the entry cap rate, because higher interest rates can put upward pressure on cap rates, though the link is not automatic. The Investor.gov REIT bulletin lists interest rates as a risk for REITs, which hold income-producing real estate. If a model assumes a lower exit cap rate than the entry cap rate, ask for the reason in writing.
Which assumptions should you challenge?
Challenge the assumptions that carry the most weight, in this order. Most of them can be checked against documents the sponsor already has.
- Rent growth. Is it supported by actual comparable rents and the current rent roll, or by a market forecast?
- Expenses. Do projections match the trailing 12 months (T-12)? Property taxes and insurance can change after a sale, depending on the jurisdiction and the insurer, so check how the model handles that.
- Vacancy and credit loss. Is it based on history, or on the best month?
- Renovation budget and timing. Does it include a contingency, and does the lease-up schedule allow for units that sit empty during work?
- Debt terms. Is the rate fixed or floating? Is there an interest-only period, and what happens when it ends?
- Maturity. When does the loan come due, and what is the plan if refinancing is unavailable?
- Reserves. Are capital expenditures and working capital funded at closing?
- Fees. How much of the property's income is paid to the sponsor before investors?
When a 506(b) deal accepts non-accredited investors, Rule 502(b) requires specified information, including financial statements, to be furnished to them a reasonable time before sale. For accredited investors it is not required, though antifraud rules still apply, so ask for the numbers either way. Pair this with our vetting checklist and the questions to ask a sponsor. Then learn how returns are measured in equity multiple, IRR and cash on cash.
Our take
Our take: show the stress case. A sponsor who publishes only the base case is asking investors to underwrite the sponsor's optimism. A sponsor who shows that the deal still covers its debt when rents slip and expenses rise is showing how they think.
We also think DSCR alone is a poor test. A deal at 1.33x with a floating-rate loan and a balloon maturity can be riskier than a deal at 1.20x with fixed debt and a long runway. Read the loan terms next to the ratio.
Trade-offs and who this is not for
Underwriting is a model, and a model is only as good as its inputs. It helps you decide, but it cannot remove uncertainty.
- Spreadsheets create false precision. A return shown to one decimal looks exact. It is a forecast.
- Cap rates are market-specific. A 7.0% cap rate in one market and property class says little about another.
- Ratios hide timing. A good DSCR in year one does not tell you about year four.
- Not a substitute for diligence. Rent rolls, T-12s, inspections, title and loan documents are still needed.
- Not for investors who will not read it. If you plan to rely only on the sponsor's headline return, spend your time on how to vet the sponsor instead.
How DoorRaise fits in
Underwriting is the sponsor's work and the investor's homework. DoorRaise handles the equity raise for sponsors of 5+ unit apartment buildings under Rule 506(b) or 506(c). It is software, legal document preparation, escrow coordination and verification services. We do not model deals, recommend or rank offerings, or give investment, legal or tax advice. We take 0% of the raise or profits.
For checks, a "verified" label means DoorRaise checked specific listed facts: sponsor identity and background including a Rule 506(d) check, the purchase contract, the title commitment and the lender term sheet. It does not mean the investment is good. The three flat fees are $500 at setup, $5,000 at closing (paid from funds raised, only if the deal closes) and $3,500 a year while you own the property. State filing fees are included in the closing fee. See flat-fee pricing.
Ready to raise? Create your free sponsor page or see pricing.
FAQ
Does NOI include debt payments?
No. NOI is before debt service, before depreciation and before income taxes.
What is a good cap rate?
There is no single answer. It depends on the market, property quality, interest rates and the time period. Compare to similar recent sales in the same market.
What DSCR do lenders want?
It varies by lender and loan type, and it changes over time. Ask the sponsor what the loan requires and what the property is projected to deliver, then check both against your own stress case.
What is the T-12?
The trailing 12-month operating statement, showing actual income and expenses for the last year. It is the best check on a sponsor's expense assumptions.
What is the difference between cap rate and cash-on-cash return?
Cap rate measures the property's NOI against its price and ignores debt. Cash-on-cash return measures cash paid to investors against the equity invested, after debt. See equity multiple, IRR and cash on cash.
Should I trust a sponsor's underwriting?
Treat it as a starting point. Ask for the rent roll and T-12, run your own stress case and compare the loan terms to the assumptions.
Sources
- IRS, Partner's Instructions for Schedule K-1 (Form 1065)
- 17 CFR 230.502, General conditions to be met
- 17 CFR 230.506, Exemption for limited offers and sales
- Investor.gov, Investor Bulletin: Publicly Traded REITs
- NOI, cap rate, DSCR and break-even occupancy are standard industry formulas. The arithmetic in this post was recomputed independently.
The examples are simplified illustrations, not projections or market benchmarks. This article is general information, not legal, tax or investment advice. Talk to a securities attorney and a CPA about your deal. DoorRaise is not a law firm, broker-dealer, investment adviser or funding portal.