Cap rate and cash-on-cash return are the two numbers every rental investor quotes, and they get used interchangeably far more often than they should. They measure different things, they move differently when you change the financing, and a deal can look fine on one and poor on the other. Here is the difference, with one property carried all the way through.
Cap rate: what the property earns, ignoring the loan
Cap rate = Net operating income ÷ Purchase priceNet operating income (NOI) is rent minus operating expenses: vacancy, management, maintenance, capital reserves, taxes, insurance. The mortgage is deliberately left out. That is what makes cap rate comparable across buyers: a cash buyer and an 80%-leveraged buyer see the same cap rate on the same property. It is a yield on the asset. (Our cap rate and NOI page pins down exactly which line items go into NOI.)
Cash-on-cash: what your cash earns, after the loan
Cash-on-cash = Annual pre-tax cash flow ÷ Cash investedCash flow is NOI minus the annual mortgage payment. Cash invested is the down payment plus closing costs plus any upfront repairs. Cash-on-cash is a yield on your money, and it changes every time you change the down payment or the interest rate, even though the property has not changed at all.
One property, both numbers
A single-family rental listed at $250,000 renting for $2,200 a month. We will use REIzer's default operating assumptions, which are national rules of thumb and should be replaced with local actuals when you have them.
| Line | Annual |
|---|---|
| Gross rent ($2,200 × 12) | $26,400 |
| Vacancy (5%) | −$1,320 |
| Management (8%) | −$2,112 |
| Maintenance (5%) | −$1,320 |
| Capital reserves (5%) | −$1,320 |
| Property taxes | −$3,000 |
| Insurance (about 0.6% of value) | −$1,500 |
| Net operating income | $15,828 |
Cap rate: $15,828 ÷ $250,000 = 6.3%. In many markets that is a respectable number, and on its own it would get this deal a second look.
Now finance it: 25% down, a 30-year loan at 6.75%, and 2% closing costs.
| Line | Amount |
|---|---|
| Down payment | $62,500 |
| Closing costs | $5,000 |
| Cash invested | $67,500 |
| Loan | $187,500 |
| Monthly payment | $1,216 |
| Annual debt service | $14,593 |
| NOI | $15,828 |
| Annual cash flow | $1,235 |
Cash-on-cash: $1,235 ÷ $67,500 = 1.8%. About $100 a month, on $67,500 of your capital, with every vacancy and repair coming out of that margin first.
Same house. Same rent. A 6.3% cap rate and a 1.8% cash-on-cash return, and both are correct.
Why they diverge
Cash-on-cash is cap rate after the loan has taken its share. When the loan's cost (here, roughly 7.8% of the loan amount per year once principal is included) is higher than the property's cap rate, leverage hurts: every borrowed dollar earns 6.3% and costs 7.8%. Cash-on-cash ends up below the cap rate, and the more you borrow, the further below it falls.
Run the same deal all-cash and the gap closes: $15,828 of NOI on $255,000 invested is 6.2%, almost exactly the cap rate, because there is no loan to take a share.
That is the rule of thumb worth memorizing: leverage only helps cash-on-cash when the cap rate is above the cost of debt. At today's rates that is a high bar in a lot of markets, and it is why so many deals that "have a good cap rate" produce almost no cash.
The number that ties them together
Lenders do not look at cash-on-cash; they look at the debt-service coverage ratio:
DSCR = NOI ÷ Annual debt service = $15,828 ÷ $14,593 = 1.08Most DSCR lenders want 1.20 to 1.25. At 1.08 this deal covers its mortgage with 8% to spare, which is the same thin cushion the $1,235 of cash flow was telling you about, just expressed the way the bank expresses it. When cap rate looks fine and cash-on-cash looks bad, DSCR is usually the number that explains why. The DSCR page covers the thresholds in more detail.
Which one to use
- Comparing properties or markets: cap rate. It strips out the financing so you are comparing assets.
- **Deciding whether to put your money in:** cash-on-cash. It is the return you actually earn, and it is what you should compare against your other options for the same cash.
- Deciding whether the deal can carry its own loan: DSCR.
REIzer's rental analyzer reports all three on every run, plus the stress tests that show how far rent can fall or rates can rise before each one breaks. Quoting one of them without the other two is how a 6.3% cap rate turns into a $100-a-month rental.