Cap Rate vs Cash-on-Cash Return: Which Should You Use?
Cap rate measures the asset, cash-on-cash measures your position in it. Here is the difference, a worked example showing both, and how to spot negative leverage before you buy.
Cap rate measures a property's unleveraged return, net operating income divided by purchase price, and it ignores your financing entirely. Cash-on-cash return measures your leveraged return, annual pre-tax cash flow divided by the cash you actually invested. Use cap rate to compare properties, and cash-on-cash to compare deals.
What is cap rate?
Capitalization rate is net operating income divided by property value or purchase price.
Cap Rate = Net Operating Income / Purchase Price
Net operating income, or NOI, is gross rental income minus vacancy and minus all operating expenses. Critically, NOI excludes mortgage principal and interest, because cap rate is deliberately financing agnostic. It also excludes capital expenditures in the strict definition, though many investors include a reserve, which is one reason quoted cap rates are not always comparable across sources.
Cap rate describes the asset, not the buyer. Two investors buying the same building at the same price get the same cap rate even if one pays cash and the other borrows 80 percent.
What is cash-on-cash return?
Cash-on-cash return is annual pre-tax cash flow divided by total cash invested.
Cash-on-Cash = Annual Pre-Tax Cash Flow / Total Cash Invested
Cash flow here is NOI minus debt service. Total cash invested is your down payment plus closing costs plus any rehab you funded out of pocket.
Cash-on-cash describes your position in the deal. Two investors buying the identical building at the identical price get very different cash-on-cash returns depending on their loan terms.
Cap rate vs cash-on-cash: side by side
| Cap rate | Cash-on-cash return | |
|---|---|---|
| Formula | NOI / purchase price | Annual cash flow / cash invested |
| Includes debt service | No | Yes |
| Includes down payment size | No | Yes |
| Measures | The asset | Your position |
| Best used for | Comparing properties and markets | Comparing financing structures and deals |
| Changes when rates change | No | Yes, significantly |
| Works for an all cash purchase | Yes | Yes, and the two converge |
| Common blind spot | Ignores whether you can afford the debt | Ignores appreciation, principal paydown, and taxes |
Worked example with illustrative numbers
A small rental. All figures are illustrative.
| Line | Amount |
|---|---|
| Purchase price | $280,000 |
| Gross annual rent | $30,000 |
| Vacancy at 6% | ($1,800) |
| Effective gross income | $28,200 |
| Taxes, insurance, maintenance, management, reserves | ($11,400) |
| Net operating income | $16,800 |
Now add financing: 25 percent down, 30 year loan at 7.0 percent on $210,000, which is roughly $1,397 per month or $16,764 per year in principal and interest.
| Line | Amount |
|---|---|
| NOI | $16,800 |
| Debt service | ($16,765) |
| Annual cash flow | $35 |
| Cash invested | Amount |
|---|---|
| Down payment | $70,000 |
| Closing costs | $7,500 |
| Initial repairs | $6,000 |
| Total cash invested | $83,500 |
A 6.0 percent cap rate property produced essentially zero cash-on-cash return. Nothing is wrong with the arithmetic. The financing simply consumed the entire spread, because the cost of debt was above the cap rate.
The same property with different financing
| Structure | Cash invested | Annual cash flow | Cash-on-cash |
|---|---|---|---|
| All cash | $293,500 | $16,800 | 5.7% |
| 25% down at 7.0% | $83,500 | $35 | 0.04% |
| 40% down at 7.0% | $125,500 | $3,388 | 2.7% |
| 25% down at 5.5% | $83,500 | $2,491 | 3.0% |
Which one should you use?
Use both, for different questions.
Use cap rate when you are comparing properties or markets. Because it strips out financing, cap rate lets you put a duplex you would buy with a conventional loan next to a fourplex you would buy with a DSCR loan and see which asset produces more income per dollar of price. It is also how commercial value is set: value equals NOI divided by market cap rate, so raising NOI raises value directly.
Use cash-on-cash when you are deciding whether to do this specific deal. It answers the question that actually determines whether you can hold the property: what does this return on the money leaving my bank account?
Use them together to detect negative leverage. When your loan constant, meaning annual debt service divided by loan amount, exceeds the cap rate, borrowing lowers your return instead of raising it. In the example above, the loan constant is about 7.98 percent against a 6.0 percent cap rate. Leverage was working against the investor, and more leverage would have made it worse. When the cap rate is above the loan constant, leverage amplifies returns and a larger loan improves cash-on-cash.
That single comparison, cap rate versus loan constant, is the most useful thing these two metrics do together.
What both metrics leave out
Neither is a total return figure. Both ignore:
- •Appreciation. Often the largest component of long-run return, and entirely absent from both.
- •Principal paydown. Your tenant reducing your loan balance is real equity that shows up in neither number.
- •Tax effects. Depreciation, deductions, and your personal bracket change the actual outcome materially.
- •Capital expenditures. A roof at year six does not appear in either metric unless you reserve for it, and many quoted numbers do not.
- •Rent growth. Both are single-year snapshots.
What is a good cap rate or cash-on-cash return?
There is no universal threshold, and be skeptical of anyone who quotes one. Cap rates are market and asset specific: stable, high-demand metros trade at lower cap rates because buyers accept less current income in exchange for lower risk and better appreciation prospects, while higher cap rate markets typically carry more vacancy, turnover, or capital risk. A low cap rate is not automatically a bad buy and a high one is not automatically a good one.
For cash-on-cash, the honest benchmark is your own alternative uses of capital and the risk you are taking. What matters more than hitting a number is that your assumptions are real: actual market rent rather than the seller's pro forma, a vacancy rate that reflects the submarket, and maintenance and capital reserves that survive a bad year.
Run both before you buy
Calculate your leveraged return with the free cash-on-cash calculator, then model the full property including expenses and NOI with the rental property calculator. Test how financing changes the answer using the mortgage calculator and check your entry costs with the closing costs calculator. Every calculator is free and requires no signup, and the full set is listed at free tools.
Both metrics depend on getting the property value and the rent right in the first place. Resideline produces valuations and rent estimates from visible, adjustable comps rather than a black box, and live valuations currently cover 31 US states.
Frequently Asked Questions
Is cap rate or cash-on-cash more important?
They answer different questions, so use both. Cap rate compares properties and markets because it strips out financing. Cash-on-cash tells you what this specific deal returns on the money leaving your bank account, which is what determines whether you can actually hold the property.
Does cap rate include the mortgage payment?
No. Cap rate is net operating income divided by price, and NOI deliberately excludes principal and interest. That is the point: two buyers of the same building at the same price get the same cap rate regardless of how each one financed it. Cash-on-cash is the metric that includes debt service.
What is a good cash-on-cash return on a rental?
There is no universal threshold, and quoted benchmarks usually ignore the market, asset class, and risk involved. The honest test is whether the return beats your alternative uses of the same capital for the risk you are taking, and whether the underlying assumptions are real: actual market rent, a vacancy rate that matches the submarket, and maintenance and capital reserves that survive a bad year.
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