Income property methodology

NOI mechanics

NOI = Gross Potential Rent
      − Vacancy & Credit Loss
      − Operating Expenses

Operating Expenses include:
  property taxes (post-sale reassessed)
  insurance (current quote, not seller's grandfathered)
  property management (8–10% of effective rent)
  repairs & maintenance (5–10% of effective rent)
  utilities the landlord pays
  HOA fees
  marketing/leasing
  accounting/legal

Operating Expenses EXCLUDE:
  debt service (mortgage P&I)
  depreciation
  capital expenditures (CapEx — modeled as separate reserve)
  income taxes

The CapEx exclusion is the most-abused line in industry practice. Listing pro-formas systematically lump CapEx-grade items (replacement roof, HVAC) into "repairs and maintenance" to inflate NOI. Operator-grade methodology tracks CapEx separately as a reserve fund that reduces cash flow but not NOI — so cap rate stays comparable across deals while cash-on-cash reflects the real cash returns.

Cap rate derivation

Cap Rate = NOI / Property Value

Direct-cap valuation:
  Property Value = NOI / Cap Rate

Band-of-investment cap rate:
  Cap Rate = (LTV × Mortgage Constant) + ((1 − LTV) × Equity Yield)

  Mortgage Constant = annual debt service / loan amount
  Equity Yield = target cash-on-cash return

The band-of-investment framework reveals why cap rates compress when interest rates fall — debt becomes cheaper, the weighted- average required return falls, prices rise. It also reveals when the market has overshot: when band-of-investment cap rate exceeds observed market cap rate by 100+ basis points, prices are unsustainable absent rent-growth assumptions that justify the gap.

Cash-on-cash return

Annual Cash Flow = NOI − Annual Debt Service − CapEx Reserves

Cash-on-Cash = Annual Cash Flow / Total Cash Invested

Total Cash Invested =
  Down Payment + Closing Costs + Initial Rehab

Cash-on-cash diverges from cap rate when leverage is positive (cap rate > debt cost) — cash-on-cash exceeds cap rate. Under negative leverage (debt cost > cap rate), cash-on-cash falls below cap rate and the deal's only economic justification is appreciation or rent growth.

DSCR (Debt Service Coverage Ratio)

DSCR = NOI / Annual Debt Service

Lender thresholds (Fannie Mae §B6 multifamily):
  1.20×  →  qualifying floor for most agency multifamily
  1.25×  →  more conservative, common in volatile markets
  1.10×  →  small-loan / non-recourse where higher fees offset risk

DSCR loans on small residential (1-4 unit):
  1.00×  →  break-even, qualifying floor on aggressive products
  1.20×+ →  better pricing tier, lower risk premium

DSCR underwriting uses NOI (not cash flow) so CapEx is implicitly assumed to come from somewhere else — equity contribution, owner reserves, or a refinance. A property that DSCRs at 1.20× on NOI but sits at 0.95× on full cash flow (after CapEx) is technically qualifying but financially fragile. Always run the after-CapEx DSCR as a sanity check.

Sources

• Fannie Mae Selling Guide §B6 — Multifamily underwriting + DSCR
• Damodaran NYU Stern — sector cost of capital, real-estate equity risk premiums
• NCREIF Property Index — quarterly cap-rate benchmarks
• FRED — Federal Reserve Economic Data (rate + housing series)