Cash on Cash Return vs Cap Rate: What Each One Measures

Cap rate is net operating income divided by purchase price. Cash on cash return is annual cash flow after the mortgage divided by cash invested. Cap rate measures the property. Cash on cash measures your deal.

Buy a property all cash and the two are nearly the same number. Add a loan and they separate, and the direction of the gap tells you whether the loan is helping or hurting.

The two formulas

Cap rate = net operating income / purchase price

Cash on cash return = (net operating income − debt service) / cash invested

Both start from net operating income: collected rent minus operating expenses, before the mortgage. Cap rate stops there and divides by price. Cash on cash subtracts the loan payments and divides by the cash you put in.

The Wikipedia entry on capitalization rate has the formal definition. In practice it is the yield the property would pay if you owned it outright.

The same property, three ways

A $250,000 rental with $20,105 of net operating income. Cap rate is 8.0%.

All cash. Cash invested is $262,500 including closing and repairs. Cash flow is the full $20,105. Cash on cash is 7.7%, a touch under the cap rate because closing costs and repairs added to the denominator.

25% down at 7.25%. The $187,500 loan costs $15,349 a year. Cash flow is $4,756 on $75,000 invested. Cash on cash is 6.3%.

25% down at 5%. Same loan, $12,078 a year. Cash flow is $8,026. Cash on cash is 10.7%.

Same property, same cap rate, three cash on cash returns from 6.3% to 10.7%. The cap rate did not change because the property did not change. The cash on cash return changed because the financing did.

What the gap tells you

Whether the financed return lands above or below the all-cash return depends on one comparison: the loan’s annual cost versus the cap rate.

The loan’s annual cost is a year of payments divided by the balance, sometimes called the mortgage constant. At 7.25% over 30 years it is about 8.2%. At 5% it is about 6.4%.

If the cap rate is above the constant, every borrowed dollar earns more than it costs and leverage pushes cash on cash up. If the cap rate is below the constant, every borrowed dollar loses a little and leverage pushes cash on cash down.

In the example, an 8.0% cap rate against an 8.2% constant is slightly negative leverage, which is why the financed return (6.3%) is below the all-cash return (7.7%). At 5%, a 6.4% constant against an 8.0% cap rate is positive leverage, and the financed return (10.7%) beats all cash. The leverage guide goes deeper.

When to use cap rate

Comparing properties. Two buildings with different prices, sizes and locations can be compared on cap rate because financing is out of the picture.

Judging price. If comparable properties in a submarket trade at a 6% cap rate and a listing pencils to 7.5% on honest expenses, either it is underpriced or the expenses are wrong. Both are worth knowing.

Talking to brokers, appraisers and commercial lenders. Cap rate is their language, especially on five or more units.

Estimating value. Divide NOI by the market cap rate and you have a rough value. Raise NOI by $1,000 in a 6% cap market and you have added about $16,700 of value.

When to use cash on cash return

Deciding whether you can hold it. Cash on cash is the return on your actual money after the actual mortgage. If it is negative, you are writing a check every month, whatever the cap rate says.

Comparing financing options. Twenty percent down, twenty-five, all cash, interest-only, a rate buydown: each produces a different cash on cash return on the same property. Cap rate cannot tell them apart.

Comparing against other uses of the cash. The question “should this $75,000 go into this property or somewhere else” is a cash on cash question.

Setting an offer. Fix the return you want and solve for price. The calculator does this directly.

Where each one misleads

Cap rate ignores financing, so a property with a great cap rate can be a terrible deal at today’s rates if the constant is higher. It also depends entirely on the NOI you feed it. Brokers’ pro formas often show NOI with no management, no reserves and low vacancy, which inflates the cap rate by a point or two.

Cash on cash ignores the property’s value and the loan’s paydown. A highly leveraged deal with a thin cash on cash return may still build equity fast, and an all-cash deal with a healthy cash on cash return may be tying up capital that could be working harder. It is also a single-year snapshot.

Use both. Cap rate to decide whether the property is priced right, cash on cash to decide whether your financing makes it a deal you can live with. The cap rate calculator handles the pricing side, including what the NOI is worth at a market cap rate. The calculator shows both on every run, along with the all-cash return so the leverage direction is visible at a glance.