A capitalization rate is arithmetic, not opinion: net operating income divided by value. Rearranged, value equals NOI divided by the cap rate. The formula is trivial. Everything contentious about commercial real estate valuation lives inside the two inputs, and a lender computes both differently from the person selling you the building.
That gap is not adversarial, and it is not a negotiating tactic. A seller's broker builds NOI to show the property at its best, using in-place rents and actual expenses. An underwriter builds NOI to show the property at its most durable, using market vacancy, a management fee whether or not you intend to pay one, and reserves for capital items that have not been spent yet but will be. The two numbers can differ by twenty percent on the same building, and since value is NOI divided by a small decimal, twenty percent on NOI is twenty percent on value.
What NOI includes, and what it does not
Net operating income is income from the property after operating expenses, before debt service, before income taxes, before depreciation and before capital expenditure. The exclusions matter. Debt service is out because NOI is meant to describe the property independent of how it is financed. Depreciation is out because it is not cash. Capital expenditure is out of the definition but comes back in through a reserve line, which is where lenders and sellers diverge most.
The four adjustments an underwriter almost always makes
Vacancy and collection loss
A fully leased building still gets underwritten with a vacancy factor drawn from the submarket and property type, not from the current rent roll. The logic is that leases expire and tenants leave. A pro forma showing 2% vacancy on a small multi-tenant building will typically be re-underwritten at a market figure that is higher.
Management fee
Self-managed properties often show no management expense. Underwriters usually impute a market management fee as a percentage of effective gross income, because if the property changed hands or the owner stopped managing it, somebody would have to be paid. This adjustment surprises owner-operators every time.
Replacement reserves
Roofs, parking lots, HVAC units and tenant improvements are real costs that do not appear in an annual operating statement. A reserve line, commonly stated per square foot or per unit, spreads them. The specific figure varies by property type, age and lender.
Rent normalization
Above-market rents get trimmed toward market, especially where a lease is short-dated or the tenant is related to the seller. Below-market rents are usually not marked up, because the underwriter credits what is contracted, not what could be achieved. The asymmetry is deliberate and it is one of the reasons underwritten NOI runs below pro forma NOI.
What the NOI gap does to your proceeds
At 70% leverage the broker's value supports about $3,356,000 and the underwriter's supports about $2,742,000: a $614,000 difference in proceeds. That is the gap between a deal that closes with the equity you planned and one that does not, and it came entirely from four line items on an income statement.
Which is the argument for rebuilding NOI yourself during diligence rather than discovering the underwriter's version at term sheet. The adjustments are predictable. Nothing in that list requires inside information.
Where the cap rate itself comes from
Cap rates are observed, not chosen. They come from actual transactions of comparable properties: what did buyers pay, relative to income, for buildings of this type, age, quality and location, recently. An appraiser derives them from sales and from investor surveys. A lender's underwriter will sanity-check the appraiser's selection and will not usually go below it.
What moves a cap rate
Cap rates move your value without you touching the property, so it is worth knowing what pushes them. Higher prevailing interest rates generally push cap rates up, because leveraged buyers need more income per dollar of price. Perceived risk pushes them up: single-tenant, short lease term, weak tenant credit, secondary market, older building, special-purpose improvements. Perceived durability pushes them down.
| Characteristic | Effect on cap rate | Effect on value at constant NOI |
|---|---|---|
| Long lease term to a strong tenant | Lower | Higher |
| Short remaining lease term | Higher | Lower |
| Multi-tenant with staggered expirations | Modestly lower than single-tenant | Higher |
| Special-purpose improvements | Higher | Lower |
| Secondary or thin submarket | Higher | Lower |
| Deferred maintenance | Higher, plus a direct deduction | Lower on both counts |
The arithmetic of that last column is worth internalizing. On $300,000 of NOI, moving from a 7.0% cap to a 7.5% cap takes value from roughly $4,286,000 to $4,000,000: a $286,000 swing from half a percentage point, with no change to the building at all.
Debt yield: the test that ignores cap rates
Underwriters know that value is a modeled number and that both coverage and loan-to-value can be flattered: coverage by a low rate or a long amortization, loan-to-value by an aggressive cap rate. So many desks run a third test: debt yield, defined as underwritten NOI divided by the loan amount.
Debt yield asks a blunt question: if the lender took this building back tomorrow, what unlevered return would the loan balance earn? It does not care about the interest rate, the amortization schedule or the appraiser's cap rate. In the example above, a $2,742,000 loan against $293,744 of underwritten NOI is a debt yield of about 10.7%. Minimum thresholds vary by lender, property type and market cycle.
Practically, this means three constraints run in parallel (coverage, loan-to-value and debt yield) and your loan is sized by whichever binds first. When rates are low, coverage is generous and debt yield or leverage binds. When rates are high, coverage usually binds. Knowing which one is your constraint tells you what to work on.
Building the underwriter's version yourself
You can reconstruct underwritten NOI from documents you can get during diligence. Doing it before you sign is the difference between negotiating from information and hoping the appraisal cooperates.
Rebuild NOI the way a credit desk will
- Get the trailing twelve months of actual operating statements, not an annualized quarter and not a pro forma.
- Get the current rent roll with lease start and end dates, escalations, options and any free rent or concessions.
- Read the actual leases for the largest tenants, including who pays taxes, insurance and common area costs.
- Replace stated vacancy with a market vacancy figure for that property type and submarket.
- Add a market management fee as a percentage of effective gross income, even if you will self-manage.
- Add a replacement reserve per square foot or per unit appropriate to the age and type of the building.
- Verify real estate taxes on a post-sale basis: a reassessment after purchase can move the expense materially.
- Verify insurance with a real quote on the building you are buying, not the seller's legacy premium.
- Trim any above-market or related-party rent to a defensible market level.
- Divide the result by a cap rate drawn from recent comparable sales, then check the loan that value supports.
Why does the lender use a higher vacancy than the property actually has?
Because the loan outlives the current rent roll. Leases expire, tenants leave, and the underwriter is sizing debt that has to survive that. A stabilized market vacancy assumption is a durability test, not a claim that your tenants are leaving.
I manage the property myself. Why is a management fee deducted?
Because your labor is a real cost and because the loan must survive a change in ownership or in your availability. If the lender ever had to take the property back it would hire a manager. Imputing the fee is standard on income property underwriting.
What is the difference between going-in cap rate and exit cap rate?
Going-in is NOI divided by your purchase price today. Exit is the cap rate you assume a future buyer will pay when you sell. Prudent underwriting assumes an exit cap at or above the going-in rate, because assuming you sell at a lower cap rate than you bought is assuming the market improves.
Does a higher cap rate mean a better deal?
It means more income per dollar of price, which usually means more perceived risk: weaker tenants, shorter leases, a thinner market, an older building. Higher cap rates also make debt sizing easier because value per dollar of NOI is lower but coverage per dollar of loan is higher. Neither direction is inherently good; the question is whether the risk being priced is a risk you can manage.
How do lenders treat a property with vacant space?
Generally as vacant. Underwritten NOI credits contracted rent, so speculative lease-up income is usually excluded or heavily discounted. If the plan depends on filling space, the structure often shifts toward short-term financing with a stabilization test, then a permanent loan once the leases are signed.
Can I get the underwriter to use my pro forma?
You can get specific line items accepted with evidence: a signed lease, an executed insurance quote, a contractor invoice showing a one-time expense will not recur. What generally does not get accepted is a projection of higher rents or lower vacancy without a contract behind it. Documentation moves NOI; optimism does not.
What is the relationship between cap rate and interest rate?
There is no fixed formula, but they tend to move in the same direction, because most commercial buyers use debt and need income to exceed borrowing cost. When the gap between cap rates and borrowing rates narrows or inverts, leverage stops improving returns and deals get harder to underwrite.
Which matters more, the cap rate or the NOI?
NOI, because you control it and the cap rate is set by the market. Adding $30,000 of durable NOI at a 7.5% cap adds about $400,000 of value permanently. Arguing the appraiser down half a point is a one-time conversation you will probably lose.
Where to start
Take the trailing twelve months and the rent roll on the property you are looking at and rebuild NOI with the four adjustments applied. Divide by a cap rate you can support with recent sales. Then check what loan that value supports at your target leverage, and separately what loan your NOI supports at a realistic coverage requirement. The smaller of the two is your actual proceeds.
If the two numbers are far apart, you have learned something useful before spending money on third-party reports: the deal is constrained by leverage, or by cash flow, and the fix is different in each case.
Qualified Commercial Underwriting Desk
Credit and capital markets
The Qualified Commercial underwriting desk reviews commercial real estate, dealer and Main Street files daily. The Academy is written from that work (how files are actually read, priced and declined) rather than from a rate sheet.
Educational content only. Nothing here is a commitment to lend, an offer of credit, or tax, legal or accounting advice. Program terms, timelines and thresholds vary by lender, file and market conditions, and any figures shown are illustrative.