What is the difference between cap rate and cash-on-cash return?

The cap rate is net operating income over the full purchase price, so it ignores the mortgage entirely and describes the building. The cash-on-cash return is annual cash flow over the cash you put in, so it describes your money after the loan is paid. On the default figures here they are 7.12% and 3.67%, and the gap is the cost of borrowing.

Why does the cap rate stay the same when I change the down payment?

Because nothing about the property changed. Net operating income is rent minus operating expenses and the purchase price is the purchase price; neither knows how you funded the purchase. Change the down payment and the mortgage payment, the cash flow and the cash-on-cash return all move, while the cap rate stays exactly where it was.

Is the 1% rule a real rule?

It is a rule of thumb rather than a rule, and it is a starting filter rather than an answer: monthly rent of about 1% of the purchase price is a rough sign that a property may cover its costs in markets where it originated. In the chart below the top row, 3,000 on a 300,000 property, is exactly at that line. It tells you nothing about taxes, appreciation or the condition of the building.

Why is my cash flow negative when the cap rate is positive?

Because the cap rate does not include the mortgage and the cash flow does. A property can earn a perfectly respectable return on its price and still hand you a bill every month if the loan against it is large enough. That is the third example above, and it is the situation most first-time landlords discover only after completing.

Should I include the mortgage principal in my return?

Not in the cash-on-cash figure, because that money is not in your pocket — it has moved from your bank account into your equity in the building. It is a real gain and it is simply a different kind of gain, realised when you sell or borrow against the property. Counting it as cash flow would make a property look more liquid than it is.

What should I put in for operating expenses?

Everything the property costs to own and run except the mortgage: property tax, insurance, management fees, repairs, maintenance, and a provision for the occasional large replacement. Use a realistic annual figure rather than last year's receipts, because a year without a new boiler is not a year without the cost of one. Understating this line is the single most common way a rental analysis comes out too optimistic.

Rental Property Calculator

Result

7.12%

Cap rate (%)

Cash-on-cash return (%): 3.67%
Cash flow per month: 183.27
Cash flow per year: 2,199.24
Mortgage payment per month: 1,596.73
Gross rental yield (%): 9.60%
Net operating income: 21,360.00
Down payment amount: 60,000.00
Monthly rent as a share of the price (%): 0.80%

A rental property is two investments wearing one coat. There is the building, which earns rent and costs money to run, and there is the deal you struck to buy it, which is a pile of your own cash plus a mortgage. This page prices both, and the two numbers it leads with are the ones that get confused most often. The capitalisation rate, usually shortened to cap rate, is the property's net operating income divided by its full purchase price: it asks what the building earns before anyone's financing is taken into account. The cash-on-cash return is your annual cash flow divided by the cash you actually put in, and it asks what your money is doing. On the default figures — 300,000 at a monthly rent of 2,400, 5% vacancy, 6,000 a year of operating expenses, 20% down on a thirty-year loan at 7% — the cap rate is 7.12% and the cash-on-cash return is 3.67%. Those are not two measurements of the same thing that disagree. They are measurements of two different things, and the gap between them is the cost of the mortgage. The page also returns net operating income, gross yield, the down payment amount, the monthly mortgage payment, and the rent-to-price ratio, which is there because the 1% rule is the fastest rough check in the business. Read it as a shape, not a verdict: the same property can look excellent to a cash buyer and mediocre to someone borrowing four fifths of the price. The calculator is built to be run twice on the same building for exactly that reason — once with your deposit, once with the whole price — so you can see which of the two numbers your own circumstances are exposing you to.

300,000 with 20% down at 7%, by monthly rent

Monthly rent	Gross yield	Cap rate	Annual cash flow	Cash-on-cash
1800	7.2	4.84	-4640.76	-7.73
2100	8.4	5.98	-1220.76	-2.03
2400	9.6	7.12	2199.24	3.67
2700	10.8	8.26	5619.24	9.37
3000	12	9.4	9039.24	15.07

Only the rent changes across these five rows; the price, the vacancy, the expenses, the down payment and the rate are all this page's defaults. Two things are worth seeing. The cap rate moves in step with the rent while the cash-on-cash return moves much faster, because the first is divided by 300,000 and the second by 60,000. And the range runs from a comfortable profit to a monthly loss without the rent ever looking unreasonable — 1,800 against 300,000 is a 0.6% rent-to-price ratio, which is ordinary in many cities and still leaves the owner out of pocket every month under these financing terms.

Formula

Cap rate = net operating income ÷ purchase price. Cash-on-cash return = annual cash flow ÷ down payment.

P: Purchase price
R: Monthly rent, before vacancy
v: Vacancy rate as a percentage
E: Annual operating expenses
NOI: Net operating income: effective annual rent minus operating expenses
D: Down payment percentage
C: Annual cash flow: net operating income minus twelve mortgage payments

Use the cap rate first, when you are comparing one property against another. It is the only one of the two that is independent of how the purchase is financed, so two buyers with completely different mortgages will compute the same cap rate for the same building — which is exactly why it is the number listings quote. Use the cash-on-cash return second, when you are comparing a property against the alternative uses of your own money. It is the number that answers whether this deal is better than the deposit account, and it can be negative on a property whose cap rate is comfortably positive; the reference chart below has a row showing precisely that. Note the direction the two move when you put less money down: the cap rate does not change at all, because nothing about the building has changed, while the cash-on-cash return gets more extreme in whichever direction it was already heading. Neither number includes appreciation, tax, or the principal you are repaying, all of which are real and none of which are here.

Worked examples

300,000 at 2,400 a month, 20% down
1. Effective annual rent: 2,400 × 12 = 28,800, less 5% vacancy = 27,360
2. Net operating income: 27,360 − 6,000 = 21,360
3. Cap rate: 21,360 ÷ 300,000 = 7.12%
4. Down payment: 20% of 300,000 = 60,000, so the loan is 240,000
5. Mortgage payment: 240,000 at 7% over 360 months = 1,596.73 a month, or 19,160.76 a year
6. Annual cash flow: 21,360 − 19,160.76 = 2,199.24, which is 183.27 a month
7. Cash-on-cash return: 2,199.24 ÷ 60,000 = 3.67%
The whole page in one example: the building yields 7.12% on its price, your money yields 3.67% on your down payment, and the difference is what the mortgage costs. Neither figure is wrong and neither is the 'real' one — they answer different questions.
The same property bought outright
1. Down payment: 100% of 300,000 = 300,000, so the loan is zero and the mortgage payment is zero
2. Net operating income is unchanged at 21,360, and so is the cap rate at 7.12%
3. Annual cash flow: 21,360 − 0 = 21,360, which is 1,780 a month
4. Cash-on-cash return: 21,360 ÷ 300,000 = 7.12%
With no mortgage the two ratios land on the same figure, and that is not a coincidence: both fractions become net operating income over the purchase price. If you ever see them agree while a loan is present, check the down payment field — it will be sitting at 100.
A property that does not cover its own mortgage
1. Effective annual rent: 1,200 × 12 = 14,400, less 5% vacancy = 13,680
2. Net operating income: 13,680 − 6,000 = 7,680, so the cap rate is 7,680 ÷ 300,000 = 2.56%
3. The mortgage is unchanged at 1,596.73 a month, or 19,160.76 a year
4. Annual cash flow: 7,680 − 19,160.76 = −11,480.76, which is −956.73 a month
5. Cash-on-cash return: −11,480.76 ÷ 60,000 = −19.13%
The case worth studying, because the two ratios point in opposite directions: the cap rate is still positive at 2.56%, while the cash-on-cash return is negative at −19.13%. A cash buyer would own a modestly profitable building; a buyer with this mortgage pays 956.73 a month for the privilege.

Limitations

Everything here comes from the seven numbers you type, and several of the things that decide whether a rental works are not among them. Appreciation and depreciation are absent: this is a current-income calculation, not a total-return one, and a property in a rising market can be a poor cash-flow investment for years and still make its owner money. Tax is absent, and it cuts both ways — mortgage interest and operating expenses are commonly deductible in many countries, while rental income is commonly taxable, and the net effect depends on your bracket and your jurisdiction. Transaction costs are absent: purchase taxes, legal fees, surveys and agency commissions can be several percent of the price, which is money that would otherwise be in the down payment and would lower the cash-on-cash return shown here. Your operating expenses figure has to be your own honest estimate, and it is the input people get wrong most often — the roof, the boiler, the void between tenants and the management fee are all operating expenses, and none of them are in the purchase price. Vacancy is modelled as a flat percentage of rent rather than as whole empty months, which is a simplification that flatters a property let eleven months a year. Principal repayment is not counted as a return here, though it does build your equity. Finally, no currency is attached to any figure: 300,000 is 300,000 in whatever unit you typed, and the rents, the expenses and the price must all be in the same one.

Frequently asked questions

What is the difference between cap rate and cash-on-cash return?: The cap rate is net operating income over the full purchase price, so it ignores the mortgage entirely and describes the building. The cash-on-cash return is annual cash flow over the cash you put in, so it describes your money after the loan is paid. On the default figures here they are 7.12% and 3.67%, and the gap is the cost of borrowing.
Why does the cap rate stay the same when I change the down payment?: Because nothing about the property changed. Net operating income is rent minus operating expenses and the purchase price is the purchase price; neither knows how you funded the purchase. Change the down payment and the mortgage payment, the cash flow and the cash-on-cash return all move, while the cap rate stays exactly where it was.
Is the 1% rule a real rule?: It is a rule of thumb rather than a rule, and it is a starting filter rather than an answer: monthly rent of about 1% of the purchase price is a rough sign that a property may cover its costs in markets where it originated. In the chart below the top row, 3,000 on a 300,000 property, is exactly at that line. It tells you nothing about taxes, appreciation or the condition of the building.
Why is my cash flow negative when the cap rate is positive?: Because the cap rate does not include the mortgage and the cash flow does. A property can earn a perfectly respectable return on its price and still hand you a bill every month if the loan against it is large enough. That is the third example above, and it is the situation most first-time landlords discover only after completing.
Should I include the mortgage principal in my return?: Not in the cash-on-cash figure, because that money is not in your pocket — it has moved from your bank account into your equity in the building. It is a real gain and it is simply a different kind of gain, realised when you sell or borrow against the property. Counting it as cash flow would make a property look more liquid than it is.
What should I put in for operating expenses?: Everything the property costs to own and run except the mortgage: property tax, insurance, management fees, repairs, maintenance, and a provision for the occasional large replacement. Use a realistic annual figure rather than last year's receipts, because a year without a new boiler is not a year without the cost of one. Understating this line is the single most common way a rental analysis comes out too optimistic.

References

Publication 527 — Residential Rental Property: what counts as rental income and as an operating expense, and how depreciation is treated — Internal Revenue Service (United States)
Publication 936 — Home Mortgage Interest Deduction: the rules that separate a mortgage on your home from a mortgage on a property you let out — Internal Revenue Service (United States)

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