Commercial & Multifamily Acquisition: A Primer
5 min read · Updated
The short answer
Commercial and multifamily properties are valued on the income they produce, not on comparable sales. Net operating income divided by the market capitalization rate gives the value. Because value follows income, raising rents or cutting expenses raises the asset price directly - and lenders size the loan on the property’s cash flow rather than on the buyer’s salary.
Key takeaways
- Five units or more is the dividing line: at five, residential lending rules stop applying and commercial underwriting begins.
- Value equals net operating income divided by the cap rate. NOI excludes debt service, capital expenditure, depreciation and income tax.
- Lenders size commercial loans on debt service coverage ratio, commonly requiring 1.20x-1.25x.
- Commercial loans typically carry shorter terms than their amortization, so a balloon is normal rather than exceptional.
- Because value is a multiple of income, a small permanent change in NOI moves the asset value by many times that amount.
Why five units changes everything
A duplex, triplex or fourplex is residential property. It can be financed with conventional or FHA loans, is appraised largely against comparable sales, and is underwritten against the borrower’s personal income and credit.
At five units the property becomes commercial. Financing moves to commercial lenders, valuation moves to an income approach, terms shorten, down payments rise, and the lender’s central question changes from "can this borrower pay?" to "can this property pay?"
That shift is the reason the same investor can find a fourplex straightforward and a six-unit building unfamiliar. It is not a difference of degree.
Net operating income, precisely
NOI is the property’s income after operating expenses and before financing. Getting the boundary right matters, because everything downstream is a multiple of it.
Start with gross potential rent - every unit at market rent, fully occupied. Subtract vacancy and credit loss to get effective gross income. Add other income such as parking, laundry or fees. Then subtract operating expenses: property taxes, insurance, utilities the owner pays, repairs and maintenance, property management, and a reserve for replacements.
Four things are deliberately excluded: debt service, capital expenditure, depreciation and income tax. They are excluded so the measure describes the property rather than the buyer, which is what lets two buyers with different financing compare the same asset.
The core metrics
| Metric | Formula | What it tells you |
|---|---|---|
| Net operating income | Effective gross income minus operating expenses | The property’s earning power, independent of financing |
| Cap rate | NOI divided by value | The market’s required unlevered return; lower means more expensive |
| Value | NOI divided by cap rate | What the income stream is worth at market pricing |
| DSCR | NOI divided by annual debt service | Whether income covers the loan; lenders commonly want 1.20x-1.25x |
| Cash-on-cash return | Annual pre-tax cash flow divided by cash invested | The levered return on your actual money |
| Expense ratio | Operating expenses divided by effective gross income | A sanity check against comparable properties |
How the loan gets sized
Commercial lenders start from the property. They take your underwritten NOI, apply a required debt service coverage ratio, and derive the maximum annual debt service the property can support. From that, at the quoted rate and amortization, they calculate the loan amount. Loan-to-value acts as a second, separate cap.
The practical consequence is that the binding constraint is often coverage rather than value. A property can appraise well and still support a smaller loan than expected because the income does not cover the payment at the required ratio.
Commercial loans also commonly have a term shorter than the amortization - a balloon after five, seven or ten years is ordinary. Refinance risk is a structural feature of commercial real estate rather than a sign of an unusual deal.
Due diligence that is specific to commercial
The diligence period on a commercial acquisition is longer and more document-driven than on a house, and the documents are the point.
- Rent roll and every actual lease - verify the rents, terms, deposits, concessions and any below-market legacy tenancies.
- Trailing twelve months of operating statements, reconciled against bank statements rather than accepted at face value.
- Estoppel certificates from tenants confirming their lease terms independently of the seller.
- Property condition assessment covering roof, structure, and the remaining life of major systems.
- Environmental assessment where the property type or history warrants it.
- Zoning, certificate of occupancy, and confirmation that the current use is permitted.
- Actual tax bills, and how the assessment will change on sale - a reassessment at your purchase price can eliminate the margin that made the deal work.
Where seller financing fits in commercial
Seller financing is more routine in commercial than in residential, and less freighted. Owners of smaller commercial and multifamily assets are often long-term holders with substantial equity, no remaining loan, and a real interest in spreading a gain rather than realising it all at once.
It is also used to bridge specific gaps: a property whose income has not yet stabilised, one that will not support the loan a buyer wants at current coverage requirements, or one where the buyer needs time to execute a repositioning plan before conventional debt makes sense.
The same discipline applies as anywhere else. Confirm what secures the note, whether it can be prepaid, and what happens on default - and be certain your plan for the balloon is a plan rather than an assumption.
Frequently asked questions
- What is a good cap rate for multifamily?
- There is no universally good cap rate - it is a market price rather than a quality score. Cap rates vary by metro, submarket, asset class and property age, and they move with interest rates. A low cap rate means a more expensive property relative to its income, which often reflects a market investors consider lower risk. Compare against recent sales of similar assets in the same submarket.
- What is DSCR and what do lenders require?
- Debt service coverage ratio is net operating income divided by annual debt service. It measures how comfortably the property’s income covers its loan payments. Commercial lenders commonly require a minimum of 1.20x to 1.25x, meaning income must exceed the payment by 20%-25%.
- Is a fourplex commercial or residential?
- A fourplex is residential. Properties of one to four units fall under residential lending rules and can be financed with conventional or FHA loans. At five units and above the property is treated as commercial, with different financing, underwriting and valuation.
- What is not included in net operating income?
- NOI excludes debt service, capital expenditure, depreciation and income taxes. These are excluded so the figure describes the property’s own earning power independent of how any particular buyer finances or is taxed on it.
- Why does a small increase in NOI raise the property value so much?
- Because value is NOI divided by the cap rate, a permanent increase in income is capitalised into value at a multiple. At a 6% cap rate, for example, an extra $1,000 of annual NOI corresponds to roughly $16,700 of value. This is why operational improvements matter more in commercial than in residential property.
