Underwriting
The 7% Cap Rate That Wasn't
A cap rate is only as reliable as the NOI underneath it.
The question
A marketing summary can present a commercial property as a 7% cap rate acquisition. The percentage looks specific. It looks like work already done.
The question is not whether 7% is an attractive number. The question is whether the net operating income used to produce that number would survive a reconstruction of the income and expenses.
What looks obvious
Cap rate is often treated as the shortcut for value: divide NOI by price, compare the result to other opportunities, and decide whether the return is adequate.
If the asking price is stated and the NOI is stated, the cap rate appears to be a fact. A buyer can be tempted to underwrite the percentage instead of the property.
What the formula actually says
The capitalization rate is a relationship, not an independent characteristic of the asset. Cap rate = NOI ÷ purchase price.
If the purchase price is held constant, the cap rate moves only when NOI moves. An advertised 7% cap rate is therefore an advertised NOI expressed as a percentage of the asking price. It is only as useful as that NOI.
Why advertised NOI has to be examined
Before the percentage can be relied on, the income statement behind it has to be understood. Common issues include:
- Trailing operating results versus forward assumptions. A T-12 can describe a year that already happened. A pro forma can describe a year the seller hopes will happen. They are not interchangeable.
- Missing or understated expenses. Marketing NOI sometimes omits costs a typical buyer will incur to operate the property.
- Management expense. An owner-managed property can look more profitable until a market-rate management cost is included.
- Repairs and maintenance. An unusually light year, deferred work, or expenses capitalized rather than expensed can overstate NOI.
- Replacement reserves / recurring capital. Roofs, HVAC, parking surfaces, and suite turnover still consume cash even when they are analyzed below conventional NOI rather than treated as operating expenses. They should not be ignored, and they should not be mixed into NOI inconsistently from property to property.
- Property taxes after sale. Assessed value and taxable basis can change with a transfer. The seller's current tax bill is not automatically the buyer's.
- Insurance. Coverage, deductibles, and premiums can differ materially from the amount in a trailing statement.
- Vacancy and credit loss. A statement that assumes full collection does not answer whether that collection is durable.
- Nonrecurring income. Termination fees, insurance recoveries, or other one-time items can sit inside a marketed NOI as if they will repeat.
- Owner-paid expenses that never appear in the marketing package. Utilities, landscaping, software, professional fees, or unit-level costs paid outside the operating statement still affect the investment.
Buyer underwriting should reconstruct NOI rather than accept it.
An illustrative reconstruction
The figures below are hypothetical and rounded for clarity. They are not market data, and they do not describe a real listing. The asking price is held constant so the cap-rate formula moves only with reconstructed NOI. Replacement reserves are shown separately below that NOI.
Marketing version
- Advertised NOI
- $140,000
- Advertised price
- $2,000,000
- Advertised cap rate
- 7.00%
Underwritten version
- Advertised NOI
- $140,000Starting point, not the conclusion.
- Nonrecurring income removed
- ($10,000)A one-time item that will not repeat.
- Vacancy / credit loss
- ($7,000)Allowance omitted from the marketing NOI.
- Management expense
- ($8,000)Not shown because the current owner self-manages.
- Repairs, insurance, and taxes after sale
- ($15,000)Understated operating costs and a post-sale tax adjustment.
- Normalized NOI
- $100,000
Below NOI
- Recurring capital / replacement reserve consideration
- $10,000Not deducted from the conventional NOI used for this cap-rate calculation.
Resulting cap rate at the same $2,000,000 price: $100,000 ÷ $2,000,000 = 5.00%. Check on the marketed number: $140,000 ÷ $2,000,000 = 7.00%. The $10,000 replacement-reserve consideration is not included in the $100,000 NOI used for that 5.00%.
The price didn't change. The NOI did — and the cap rate followed.
Recurring capital still has to be analyzed
This reconstruction uses conventional investment-property NOI for the cap-rate calculation. Replacement reserves and other recurring capital are not deducted as operating expenses inside that NOI.
The illustrative $10,000 still matters. It affects investor cash flow and the investment decision even though it sits below the $100,000 used in the 5.00% cap rate. Leaving it out of NOI is not the same as leaving it out of the analysis.
When comparing properties, apply the same definition consistently. Mixing a cap rate that includes reserves with one that does not — or ignoring recurring capital because it is presented below NOI — will misstate the comparison.
What can change the answer
A different reconstruction can produce a different NOI. That is the point. The work is to identify which inputs are facts, which are assumptions, and which are still unknown:
- Whether the statements are trailing, annualized, or forward.
- Whether each income line is contractual, collection-tested, or speculative.
- Whether expenses are complete, normalized, and stated on a buyer-cost basis.
- Whether replacement reserves are compared on a consistent convention — inside NOI, below NOI, or as a separate cash-flow line — rather than mixed across properties.
- Whether a lower reconstructed cap rate is still acceptable after the rest of the investment is understood: leverage, capital plan, lease risk, and alternatives.
PCG view
The cap rate is the output of the analysis, not the analysis itself. A percentage cannot be more precise than the income statement used to create it.
If the NOI has not been reconstructed, the buyer is not evaluating a 7% cap rate. The buyer is evaluating a claim about income.
Underwrite the NOI. The cap rate will follow.
This example is illustrative and hypothetical. It is not a description of a specific property, listing, or PCG client assignment, and it is not an appraisal or a recommendation.