Can the Property Cover Its Mortgage From NOI?

The most common mistake new investors make is treating a high cap rate as a guarantee of a profitable deal. The cap rate is the unlevered current yield before debt service, not the cash you keep. A property can have an 8% cap rate and still fail to cover its mortgage payment. The real question is: can the property cover its mortgage from noi? The answer depends on the debt service coverage ratio (DSCR), which divides NOI by the annual loan payment. A 6% cap rate property with $60,000 NOI and a $70,000 annual debt service produces a DSCR of 0.86. The lender rejects that deal. The cap rate and the mortgage are not interchangeable measures. One measures yield on total value; the other measures a fixed obligation against cash flow.

Net operating income (NOI) equals effective gross income minus operating expenses. It excludes debt service, capital expenditures, and income taxes. Debt service is the annual loan payment, which includes both principal and interest. The lender requires a minimum DSCR, typically 1.20 to 1.25. That means NOI must be at least 20% to 25% higher than the annual debt service. A property that meets this threshold is considered able to service its debt from its operations. One that falls below it is technically insolvent on an operating basis, even if the cap rate looks attractive.

The cap rate is a ratio of NOI to property value. The formula is Cap Rate = NOI / Price. It tells you the initial yield on an all-cash purchase. It does not tell you anything about financing. Debt service is a separate claim on NOI. A property with a 6% cap rate and NOI of $60,000 is valued at $1,000,000. If annual debt service is $65,000, the DSCR is 0.92. The property cannot cover its mortgage from NOI. The cap rate is 6%, but the deal fails. Change the cap rate to 8% and NOI becomes $80,000. The DSCR becomes 1.23, and the property passes. The cap rate and debt service interact through NOI, but they are not interchangeable. The cap rate measures yield before leverage; debt service measures the cost of leverage after yield.

Use the following inputs from the fact sheet. Purchase price: $1,000,000. Cap rate: 8%. NOI: $80,000. Annual debt service: $65,000. DSCR = $80,000 / $65,000 = 1.23. This meets the typical lender threshold of 1.20. The property covers its mortgage.

Now change the cap rate to 6%. NOI: $60,000. Annual debt service stays at $65,000. DSCR = $60,000 / $65,000 = 0.92. The property fails. The cap rate dropped by 200 basis points, but the debt service obligation did not change. The fixed nature of the loan payment is the missing obligation that the cap rate alone cannot capture.

Failure Case: Negative NOI

If NOI is negative, the cap rate formula is undefined. A property with negative NOI cannot cover any debt service. Analysis shifts to land value or redevelopment. This is not a theoretical edge case. Properties with deferred maintenance, high vacancy, or non-market leases produce trailing NOI that is negative or near zero. Using a pro-forma stabilized NOI that assumes full occupancy can mask this problem. A 5% vacancy allowance and a market rent adjustment are standard industry conventions. Ignoring them produces a DSCR that looks safe on paper but fails in practice.

The calculation has three steps. First, determine the stabilized NOI. Use effective gross income minus operating expenses. Include a vacancy allowance, typically 5% to 10% depending on the market and property type. Second, find the annual debt service. Use a commercial mortgage calculator to compute the monthly payment for the loan amount, interest rate, and amortization period. Multiply by 12 to get the annual figure. Third, divide NOI by annual debt service. The result is the DSCR.

Example With Specific Numbers

Property value: $1,200,000. Cap rate: 7.5%. NOI: $90,000. Loan: $960,000 at 6.5% interest, 25-year amortization. Monthly payment: $6,469. Annual debt service: $77,628. DSCR = $90,000 / $77,628 = 1.16. The property fails the 1.20 threshold. The buyer must either negotiate a lower price, put down more equity, or accept a higher interest rate.

What the DSCR Tells You

A DSCR of 1.20 means NOI is 20% higher than debt service. That buffer covers operating expense increases, vacancy, and capital expenditures. A DSCR below 1.20 means the property is at risk of cash flow insolvency. Lenders enforce this threshold because it protects their interest. A buyer who ignores it is taking on a property that cannot support its own debt.

The single thing that most often goes wrong is using trailing NOI instead of stabilized NOI. Trailing NOI is the actual income from the last 12 months. It may include one-time repairs, non-market rents, or temporary vacancies. A seller's pro-forma stabilized NOI assumes normalized occupancy and market rents. The difference can be 10% to 20% of NOI. A property that shows a DSCR of 1.25 on pro-forma NOI may have a DSCR of 1.05 on trailing NOI. The buyer signs the loan and discovers six months later that the property cannot cover its mortgage. The fix is to underwrite from audited operating statements, not from the offering memorandum. If the seller will not provide trailing NOI, walk away.