How to underwrite an investment property, step by step.

Every listing for an income property comes with a number on it. Usually it's a cap rate, sometimes a "pro forma" cap rate, and every so often a cap rate that looks like it was calculated by somebody who really, really wants to sell you a building.

Here's the thing: that number is the seller's opinion. Your job, before you write an offer, is to build your own. That's underwriting. It sounds intimidating, but at its core it's a few formulas and a lot of healthy skepticism. Once you can do it, you'll never look at an offering memorandum the same way again.

Let's walk through how to underwrite an investment property the way a commercial broker or lender does, using a real example from top to bottom.

Step 1: Start with income, the honest way

Underwriting builds from the top line down. These are the terms you'll see on every commercial pro forma:

• Gross potential rent (GPR): what the property would collect if every unit were leased at its current or market rent, all year, and everyone paid.
• Vacancy and credit loss: the reality adjustment. Units turn over, and some tenants don't pay. Many underwriters use 3% to 7% for stabilized multifamily depending on the market, and lenders often apply their own minimum, even if the building is currently full.
• Other income: laundry, parking, storage, pet fees, utility reimbursements.
• Effective gross income (EGI): GPR, minus vacancy and credit loss, plus other income. This is the money that actually shows up.

The single most important habit: underwrite actual rents from the rent roll, not the "market" rents in the brochure. If the seller says the units could rent for $300 more, great. That's the upside you're buying, and you shouldn't pay the seller for it up front.

Step 2: Expenses, where deals quietly die

Operating expenses are the costs of running the property. Not the mortgage, not depreciation, not your income taxes. The usual suspects:

• Property taxes. In California, this is the one that catches people. Under Proposition 13, the property is reassessed at your purchase price when it changes hands. The seller's tax bill, based on what they paid years ago, is irrelevant to you. Underwrite at roughly 1% of your price plus the local voter-approved levies and any special assessments. In many areas the all-in rate lands somewhere around 1.1% to 1.25%, but check the actual tax rate area for the parcel.
• Insurance. Get a real quote during due diligence. In parts of California, premiums have climbed sharply, and an estimate from last year can be badly off.
• Property management. Include it even if you plan to self-manage. Lenders will, buyers will when you sell, and your time isn't free.
• Repairs and maintenance, utilities, landscaping, administrative costs and, on the commercial side, any expenses not passed through to tenants.
• Replacement reserves. Money set aside for roofs, HVAC and other big-ticket items. Lenders commonly require a reserve per unit per year.

Ask for the trailing twelve months of operating statements (the "T-12"), and compare it with the seller's pro forma line by line. If the pro forma expenses are much lower than what actually happened last year, you need a very good reason to believe them.

Step 3: Net operating income

NOI = Effective Gross Income − Operating Expenses

NOI is the property's earning power before financing and before income taxes. It's the most important number in commercial real estate, because value, loan size and returns all flow from it. Debt service, depreciation and capital improvements are not operating expenses, so they don't come out of NOI.

Let's underwrite a deal

Here's an illustrative 10-unit apartment building listed at $4,000,000. Average in-place rent is $2,750 a month. (The numbers are hypothetical and rounded, but they're built to look like a real California deal.)

Step 4: Cap rate, the price check

Cap rate = NOI ÷ Price

$197,830 ÷ $4,000,000 = 4.95%. That's your actual going-in cap rate on in-place income. If the listing advertised a 5.75% cap, now you know the gap came from somewhere: maybe the seller's tax bill, maybe a missing management fee, maybe market rents nobody is paying yet. Spotting that difference is worth a lot of negotiating leverage.

Cap rates also work in reverse. If similar buildings trade at a 5% cap, this NOI supports about $3.96 million. That's how commercial value is set.

Step 5: Debt, and why DSCR runs the show

Now let's finance it. Say a lender offers 65% loan-to-value, which is $2,600,000, at an illustrative 6.25% interest rate on a 30-year amortization. The annual debt service is about $192,100.

DSCR = NOI ÷ Annual Debt Service

$197,830 ÷ $192,100 = 1.03x. That's a problem. Most commercial and agency lenders want at least 1.20x to 1.25x. So the lender doesn't size the loan on loan-to-value; it sizes it on coverage.

At a 1.25x requirement, the maximum annual debt service is $197,830 ÷ 1.25 = $158,264. At the same rate and amortization, that supports a loan of about $2,142,000, or roughly 54% loan-to-value. You'll need about $1.86 million of equity, plus closing costs, not the $1.4 million you were planning on.

This is the number one surprise for investors moving from residential into commercial. Your appraisal can be perfect and you'll still get a smaller loan if the income can't cover it. Lenders may also look at debt yield (NOI ÷ loan amount), which here is about 9.2%. It's a quick read on how much income backs each dollar of debt, regardless of interest rate.

Step 6: Cash flow and cash-on-cash return

Cash-on-cash = Annual pre-tax cash flow ÷ Total cash invested

NOI of $197,830 minus debt service of $158,264 leaves about $39,566 of annual cash flow. Divided by roughly $1,858,000 of equity (before closing costs), that's a cash-on-cash return of about 2.1%.

Not exactly fireworks. And that's the point of underwriting: you see it before you own it. A 2.1% cash yield can still make sense for a buyer who values principal paydown, depreciation, long-term appreciation and a high-quality location. But you should buy it on purpose, not by accident.

Step 7: Break-even occupancy, your margin of safety

Break-even occupancy = (Operating Expenses + Debt Service) ÷ Potential Gross Income

($121,670 + $158,264) ÷ ($330,000 + $6,000) = about 83%. The building can lose roughly 17% of its potential income before it stops covering its own bills. That's a useful stress test, and you should run others too: what if insurance rises 25%? What if the rate on your refinance in seven years is two points higher? Good underwriting asks what breaks first.

Step 8: Where the upside lives

Back to that seller's claim that rents could be $300 higher. Say that over time, as units naturally turn over, you bring the average to $3,050. Gross potential rent rises by $36,000 a year. After 5% vacancy and higher management fees, NOI climbs by roughly $32,000, to about $230,000. At a 5% cap rate, that's a building worth roughly $4.6 million.

That's forced appreciation, and it's real. But notice how it's underwritten: as a plan with a timeline, not as today's income. In California, the statewide Tenant Protection Act (AB 1482) caps annual increases on many covered units for existing tenants at 5% plus CPI, with a 10% maximum, and some cities have stricter local rent control. Rents usually reset to market at turnover, which takes time. Model that honestly and you'll know exactly what the upside is worth, and how much of it you're willing to pay the seller for.

Step 9: The full picture, IRR and equity multiple

For longer holds, investors project cash flows year by year, plus a sale at the end, and calculate two more metrics:

• Internal rate of return (IRR): the annualized return that accounts for the timing of every dollar in and out.
• Equity multiple: total cash returned divided by total cash invested. A 2.0x multiple means you doubled your money, regardless of how long it took.

The exit assumption matters enormously here. A common discipline is to assume an exit cap rate a bit higher than today's going-in rate, so your projected profit doesn't depend on the market getting more generous.

The underwriting checklist

• Rent roll and every lease, matched to the T-12
• Property taxes reassessed to your price
• A real insurance quote
• Management fee and reserves included, even if you self-manage
• Loan sized on DSCR, not just loan-to-value
• Cash-on-cash, break-even occupancy and a few stress tests
• Upside modeled as a plan, under the rent rules that actually apply

Underwriting doesn't make a deal good or bad. It just tells you the truth about it, early enough for the truth to be useful.

That's literally how every Masiv engagement starts. Send us an address and we'll send back a written underwriting summary, built from the actual numbers, so you can decide with the math in front of you.

This article is general information, not tax, legal or financial advice. Tax law, lending guidelines and local ordinances change, and every situation is different, so talk with your CPA, attorney and lender before acting on any strategy here. Masiv Real Estate Inc · DRE #02025676.