Cap rate vs. cash-on-cash: What do they mean and when to use them

What does a 7% cap rate mean? What about 3% cash-on-cash? Which one is better? When do I use one vs. the other? These are all questions I had when I initially started investing in real estate. The metrics may be confusing at first, especially when a listing shows a good return but your calculator says there's barely any money left each month.

That happened with one of the DoorHunter properties we'll look at below. Under the assumptions in this article, it has a 7.28% cap rate but only about $43 a month left after the mortgage and reserves. Before making an offer, I want to understand where that difference comes from.

I use cap rate to compare operating income with the price, then cash-on-cash return to check the income on the cash I'm investing. The three listings below show why I want to understand both before making an offer.

What is cap rate?

Cap rate, short for capitalization rate, compares a property's annual net operating income with its purchase price or current value. Net operating income, or NOI, is the income left after vacancy and operating expenses, before mortgage payments.

For a purchase, the formula is:

$$\text{Cap rate}=\frac{\text{Annual NOI}}{\text{Purchase price}}\times100\%$$

At a 7% cap rate, the property produces $7 in annual operating income for every $100 of purchase price, before financing. It doesn't mean you'll receive a 7% return on your down payment. It also doesn't mean that 7% of the rent is left over. NAR's investor guide uses this same NOI-to-price definition.

To get NOI, start with the income you expect to collect:

$$\begin{aligned} \text{Annual NOI}&=\text{Effective rental income}\\ &\quad-\text{Operating expenses} \end{aligned}$$

Effective rental income is rent after allowing for vacancy, plus other recurring income such as parking or laundry. Operating expenses include property taxes, insurance, management, routine maintenance, HOA fees, and any utilities you pay as the owner.

Mortgage principal and interest stay out of NOI. I also keep capital reserves separate in this article. Routine maintenance belongs in the operating budget; money set aside for a future roof or HVAC replacement comes out of cash flow later. Reports can treat reserves differently, so check the expense definitions before comparing cap rates.

What is cash-on-cash return?

Cash-on-cash return compares annual cash flow with the cash you've invested in the property. I use it to check what the deal leaves after financing and how much of my money it takes to get there.

First, subtract annual loan payments and capital reserves from NOI:

$$\begin{aligned} \text{Annual cash flow}&=\text{Annual NOI}\\ &\quad-\text{Debt service}\\ &\quad-\text{Capital reserves} \end{aligned}$$

Debt service means mortgage principal and interest. If your payment includes escrow for taxes and insurance, separate those amounts out so you don't deduct them twice.

Then divide annual cash flow, before personal income taxes, by the cash invested:

$$\text{Cash-on-cash return}=\frac{\text{Annual cash flow}}{\text{Cash invested}}\times100\%$$

Cash invested includes the down payment, closing costs, cash-paid renovation and setup costs, and any additional cash cushion committed to the property. Using only the down payment when you've put in more money overstates the return.

A 3% cash-on-cash return means $3 in annual cash flow for every $100 of cash invested, before personal income taxes. Cap rate compares operating income with the property's price; cash-on-cash compares cash flow after financing with my cash in the deal. Neither percentage includes appreciation or future sale proceeds.

Cap rate for residential vs. multifamily and commercial properties

You can calculate cap rate for a single-family rental, a duplex, an apartment building, or a commercial property. The math is the same. How much weight I put on it depends on the property.

For a single-family home, cap rate helps me screen the rental income against the asking price. It also helps me figure out just how good a deal is. It's a number I can use to compare two properties or two neighborhoods side by side to help indicate if I'm getting a better deal or not. However, to be honest, it's not just cap rate which I use, and it's also not the most important metric I normally look at when figuring out if I want to pursue it as a deal or not. That is much different when it comes to commercial properties though.

For larger apartment buildings and income-producing commercial properties, the relationship between income and value has a more direct role in the investment analysis. In direct capitalization, you estimate value by dividing supported NOI by a market cap rate:

$$\text{Estimated value}=\frac{\text{Annual NOI}}{\text{Market cap rate as a decimal}}$$

So if you're buying a house to rent out, cap rate is useful. Just don't assume that increasing its rent automatically increases its resale value by the same formula an investor might use for an apartment building. The three examples below are single-family rentals, and we're using cap rate to compare their projected operating income with their asking prices.

Why use cap rate, and what can it tell us?

When I'm looking through listings, I need a way to compare properties with different prices and rents. Cap rate gives me a starting point once I've put together a realistic operating budget.

A house renting for $1,650 isn't necessarily a better income investment than one renting for $1,261. The first house could cost more and have much higher taxes. Cap rate brings those operating costs and the purchase price into the comparison. We'll see that with Triskett and Kildare.

It also lets me compare the properties before choosing a loan. If one investor pays cash and another puts 25% down, the cap rate stays the same when the price and NOI are the same. That makes it easier to evaluate the property first, then work out how I'd finance it.

Cap rate can help me think about my offer too. Holding NOI constant, a lower purchase price raises the cap rate. On Kildare's projected $9,388.24 NOI, paying $120,000 instead of the $129,000 asking price would raise it from 7.28% to 7.82%. That's a hypothetical negotiated price, not an accepted offer. I'd still need to calculate the cash required and the loan payments at that price.

What cap rate can't tell us

A cap rate won't tell me how much cash I'll have left after the mortgage. It doesn't include the down payment, loan terms, closing costs, or upfront renovation spending either. A property can have positive NOI and still lose money each month after financing.

It also can't tell me whether the income in the calculation is realistic. A seller's projected market rent, a signed lease, and last year's actual collections are different starting points. I want to know whether I'm looking at current income or a projection for the property after improvements and leasing. Hamilton is a good example of why that matters.

Condition and tenant risk need their own review. Two houses can have the same cap rate while one needs a roof and the other was recently renovated. A higher rate can be a reason to investigate, but it doesn't establish that the deal is better or safer.

Finally, cap rate is an annual income-to-value snapshot. It doesn't measure appreciation, mortgage principal paydown, personal income-tax effects, or proceeds from a future sale. Even a commercial property's value can change while its NOI stays the same if market cap rates change.

I wouldn't use one target cap rate for every property or market. I'd compare similar properties in the same local market, using consistent expense assumptions and the same type of income. These examples show how the metric works; they don't establish a typical or good cap rate for either city.

Three DoorHunter properties to work through

I pulled three listings and their estimated rents from DoorHunter for this article, along with listing-reported property taxes. For insurance, I use the assumption below.

To keep the examples comparable, each uses:

• Vacancy of 5%, management of 8%, and routine maintenance of 5%, with each allowance calculated separately on gross rent.
• Insurance of $100 per month, with no HOA fees or owner-paid utilities during normal rental operations. The listings report no HOA; insurance and utility responsibility still need confirmation.
• A separate capital reserve of 5% of gross rent, deducted from cash flow rather than NOI.

For the financing comparison later, I assume 25% down, a 30-year fixed loan at 7.5%, and closing costs of 3% of the purchase price.

Kildare: a useful operating-income comparison

The Kildare property analysis starts with a $129,000 asking price and $1,261 monthly rent estimate. That would produce $15,132 in annual gross rent. Here's what remains after the operating allowances:

$$\text{Cap rate}=\frac{9{,}388.24}{129{,}000}\times100\%\approx7.28\%$$

Now compare that with Triskett. Its estimated rent is higher at $1,650 a month, but its asking price is $160,000 and the reported annual taxes are $4,557. Under the same operating assumptions, its NOI is $10,479 and its cap rate is 6.55%.

Triskett generates more operating income in dollars, while Kildare generates more operating income per dollar of asking price. That's a useful distinction if I'm deciding which listing deserves a closer look. Cap rate helps me see past the larger rent number. It still leaves the condition, neighborhood, and financing questions open.

Triskett: cap rate leaves out the renovation budget

The Triskett analysis gives us a projected 6.55% cap rate at the asking price and estimated rent. But the source listing shows that the house needs work. The purchase-price cap rate doesn't tell us how much that work will cost or how long the house will be without rental income.

Suppose, purely as an example, I budgeted $20,000 for renovations and $4,800 for closing costs. That puts acquisition and renovation cost at $184,800 before holding costs. If the finished property's annual NOI were still $10,479, its yield on that cost would be:

$$\text{Yield on cost}=\frac{10{,}479}{184{,}800}\times100\%\approx5.67\%$$

I'd get a written scope, build the budget in the rehab cost calculator, and check rent for the finished house. If the work supports higher rent, I'd update NOI too. A renovation budget by itself doesn't establish that increase, and rental downtime would affect the first year's income.

Hamilton: a high projected cap rate needs verified income

The Hamilton property analysis shows a $110,000 asking price and $1,630.66 estimated monthly rent. At that rent, projected annual NOI is $12,419.69 and cap rate is 11.29%. That's the highest of the three.

However, the listing says a long-term tenant pays below-market rent, without disclosing the amount. The 11.29% figure uses estimated market rent. I can't treat it as the return available at closing when I don't know the existing lease income.

I'd ask for the lease, current rent, and payment history, then enter the collectible lease rent into Hamilton's analysis. I'd keep a separate market-rent scenario to evaluate future potential and confirm the estimate with a local manager. When that rent could be achieved, and what turnover or improvements might cost, would affect the decision.

What the three properties leave after financing

On Kildare, 25% down means a $96,750 loan. At 7.5% over 30 years, principal and interest are about $676.49 a month, or $8,117.88 annually. The capital reserve is another $756.60 a year. The down payment and closing costs total $36,120:

$$\begin{aligned} \text{Annual cash flow}&=9{,}388.24-8{,}117.88-756.60\\ &=513.76\\[4pt] \text{Cash-on-cash return}&=\frac{513.76}{36{,}120}\times100\%\\ &\approx1.42\% \end{aligned}$$

That is the $43 monthly margin from the beginning of the article. Insurance costing $50 more per month than assumed would turn cash flow negative. The 7.28% cap rate helped us compare the operating income with the price, but I needed the loan payments and reserves to see how little room remained.

Here's the comparison across all three properties, using the same financing assumptions and estimated rents:

Same cap rate, different financing results

What if I bought Kildare with different loan terms? Keeping the price, rent, operating expenses, and reserves the same gives us this comparison. Closing costs remain 3%, and each loan amortizes over 30 years.

Cap rate stays at 7.28% in every row. Financing changes the cash I invest and the cash flow I receive. Putting 40% down improves the margin over 25% down at the same rate, but commits another $19,350. I'd weigh that against my income goals and other uses for the money.

Even the all-cash cash-on-cash return is lower than cap rate here. Closing costs increase cash invested, and capital reserves reduce spendable cash flow. The percentages only match when their income and cash bases match. An interest rate below the cap rate doesn't guarantee a better cash-on-cash return either; an amortizing loan requires principal payments too.

Try your own loan terms in the rental cash flow calculator, or adjust them in the linked property analysis. Account defaults may differ from this article. Check how percentage allowances are applied too: these examples use gross rent, while the standalone calculator applies management, maintenance, and capital reserves to collected rent after vacancy.

What Next?

Now that you have cap rate and cash-on-cash under your tool belt, go analyze some deals. If you're choosing where to look, use the guide to the best markets to invest in for 2027. It explains how I'd approach different rental strategies. Once you have a property in mind, open its detailed analysis in DoorHunter.