You’ve likely heard people talking about the 7% Rule in commercial real estate.
And if you’re new to the industry, you may be wondering: What does it really mean?
The 7% Rule is essentially a quick filter that helps you decide whether a deal is worth your time or not.
It can also tell you whether a property might start generating returns before it’s fully stabilized, which is useful context, especially since both investors and private lenders often reference this rule.
Now, the 7% is not the end-all, be-all benchmark. You shouldn’t rely on just this one metric.
But if a deal fails the 7% Rule, that’s your signal to stop and reevaluate.
There may still be potential, but only if your due diligence reveals that there’s a way to adjust the numbers — by trimming construction costs or revisiting your rent assumptions, for example — to bring it closer to target.
What does the 7% Rule really measure?
Simply put, for a CRE property to satisfy the 7% Rule, it must generate an annual net operating income or NOI that’s equal to at least 7% of the property’s total cost.
To find out if the building you want to buy passes this benchmark, add up every cost:
- Land
- Hard construction
- Soft costs
- Interest fees
- Contingencies
That total becomes your investment basis.
From there, you ask: Can this project generate an NOI of at least 7% of its total cost?
For example, if your development project will cost $50 million all-in, the target NOI should be at least $3.5 million per year:
$50,000,000 × 0.07 = $3,500,000
The NOI refers to the income you’ll get after operating expenses but before debt service and leasing commissions, so it reflects your asset’s performance without being affected by your financing or exit strategy.
In short, you can use this rule to remove deals that won’t give you optimum returns, especially when you’re dealing with tight capital and unforgiving underwriting.
Why do large capital groups take the 7% Rule seriously?
The 7% Rule makes it easy to compare several CRE property deals at once.
If a deal clears 7%, that means you have leeway to absorb risk, whether that’s a spike in interest rates or softening rates.
If your project earns a higher NOI, it becomes easier to meet the lender’s minimum DSCR and find financing in general, as investors and lenders prioritize deals with stronger returns in markets where capital is limited.
If your deal doesn’t meet the 7% Rule, you might have a harder time getting approved for a loan.
What should you do if your deal doesn’t reach 7%?
A deal is not necessarily a bad deal just because your initial underwriting shows a return that’s lower than 7%.
You may be able to fix some areas.
Land price –
Are you overpaying for entitlement risk? If the land isn’t yet entitled or cleared, structure the deal so that the price adjusts based on what the seller delivers — like final permits or environmental approvals. This protects your downside.
Hard costs –
Focus your construction budget on improvements that will actually allow you to charge higher rents.
If your market doesn’t care about rooftop decks or luxury fitness centers, don’t build them.
Soft costs –
Overruns here often go unnoticed. These cuts can save six figures without touching the core product.
Reviewing your consultant contracts line by line to see where scope might overlap or where you might be paying for optional services.
Remove anything that’s not required for permitting or lender approval. Look at your study list.
Are you sure that you’re not commissioning multiple traffic or market reports? Confirm whether the lender or city actually requires all of them.
Revenue assumptions –
Check whether your pro forma uses realistic rents and lease-up timelines. Are you using trailing income instead of projected stabilized NOI?
Trailing income reflects the current state of the property, which might include vacancies or below-market leases — it doesn’t tell you what the property will earn once it’s fully leased and at market rents.
Make sure your rent comps are based on properties in the same submarket and asset class.
Are you pulling numbers from newer or more desirable areas? Then your revenue assumptions may be inflated.
Take a hard look at your stabilization timeline.
If you’re assuming you’ll reach full occupancy in six months when similar projects take twelve, your revenue curve may be too steep, and that could be throwing off both your NOI and your financing assumptions.
Capital stack –
Only close on your construction loan when you’re 100% sure that your permits and contractors are ready to go.
If you secure your loan too early, you might start accruing interest before you even break ground.
You don’t want to be paying for this carrying cost if your project gets delayed due to permitting issues or material shortages.
How does the 7% Rule compare to the 1% Rule?
The 1% Rule helps you evaluate simple rental cash flow, while the 7% Rule gives a fuller picture for more sophisticated investments.
Based on the 1% Rule, your rental property should bring in monthly rent equal to at least 1% of its purchase price.
If your property costs $2,000,000, then your target rent should be at least $20,000 per month.
If it rents for less than that, then it can’t generate enough cash flow after expenses.
The 7% Rule is better suited for complex deals like commercial or mixed-use properties where you’re looking at full project costs and net income, not just rent vs. purchase price.
You might not hit the 1% Rule in expensive or supply-constrained markets, but you could still hit 7% on total project cost if you plan your build or financing carefully.
Does the 7% Rule really tell the whole story?
No. Given its limits, you shouldn’t consider the 7% Rule as a guarantee.
That’s because it doesn’t account for property taxes and insurance premiums, and also doesn’t reflect the impact of financing.
Build your next deal
At Private Capital Investors, we work with commercial real estate borrowers who need flexible capital and realistic underwriting.
Is your deal stuck below the 7% mark? Bring it to us anyway.
We’ll go through the numbers and potentially structure a financing solution that makes the deal viable.
