The Reserves Line That Quietly Kills Your Returns

Two investors underwrite the same building and reach different answers — not because the property changed, but because one of them left out a line. It's the most common, most quietly expensive mistake in the spreadsheet: skipping reserves.

Take a deal with $300,000 of gross potential rent. Underwritten without a reserve line, it might show $180,000 of NOI and pencil to a 6.5% cap rate at the purchase price, with a cash-on-cash return that clears your hurdle. Now add reserves the way the asset actually consumes them. At a 5%-of-gross-rent convention — a reasonable default for both multifamily and many commercial assets — that's $15,000 a year set aside for the roof, the HVAC, parking-lot and turn costs, the capital items that don't show up monthly but absolutely show up. NOI drops to $165,000. The true cap rate falls to roughly 6.0%. Levered cash flow and cash-on-cash come down with it, and the IRR gives back several points over the hold.

Nothing about the building got worse. The only thing that changed is that one version told the truth about what it costs to own the asset and the other didn't.

This is exactly why the convention matters: a broker quotes the pre-reserves number because it's bigger and because reserves are the buyer's problem, not the seller's. But you live on the post-reserves cash flow. The roof is going to need replacing whether or not you budgeted for it; pretending otherwise doesn't make the money appear. Underwriting without reserves doesn't make a deal better — it just moves the bad news from your model to your bank account, usually in year three.

The lesson: reserves are not conservative accounting you can dial up or down to make a deal work — they're an estimate of real, deferred capital cost. Carry them, size them to the asset and its age, and judge cash flow on the post-reserves number. The cleanest way to read a deal is to look at the cap rate pre-reserves (so it's comparable to how the market quotes), and the cash flow, coverage, and returns post-reserves (because that's what you actually receive). A model that can't survive an honest reserve line was never as good as the flyer said.

Run a deal both ways in the cap rate calculator. For how reserves flow through a full underwrite, see the guides under Learn.