The two formulas side by side
Both are one-year, before-tax measures; the difference is whether the loan is included.[1]
| Cap rate | Cash-on-cash return | |
|---|---|---|
| Also called | Overall capitalization rate, "free and clear" rate | Equity dividend rate |
| Numerator | NOI | Before-tax cash flow (NOI − debt service) |
| Denominator | Price or value | Cash invested (down payment, closing costs, repairs) |
| Includes the loan? | No | Yes |
| Same for every buyer? | Yes, for the same NOI and price | No: depends on each buyer's loan |
| Main use | Valuing and comparing properties | Judging the return on your own cash |
One property, four ways to pay for it
A $500,000 rental with $35,004 of NOI has a 7.00% cap rate whatever the buyer does. Its cash-on-cash return depends entirely on the financing (closing costs of $15,000 included in the cash invested):
| Financing | Cash invested | Annual debt service | Cash flow | Cash-on-cash |
|---|---|---|---|---|
| All cash | $515,000 | $0 | $35,004 | 6.8% |
| 25% down at 5% | $140,000 | $24,157 | $10,847 | 7.7% |
| 25% down at 6.5% | $140,000 | $28,443 | $6,561 | 4.7% |
| 25% down at 7.5% | $140,000 | $31,465 | $3,539 | 2.5% |
With all cash, cash-on-cash is a little below the cap rate because closing costs are part of the cash invested. With a 5% loan it rises above the cap rate; at 6.5% and 7.5% it falls below it, and at 7.5% most of the cash flow is gone.
Positive and negative leverage
Borrowing raises cash-on-cash only when the property earns more on its price than the loan costs to carry. The cost to compare is the loan constant, the annual payment divided by the loan, which always exceeds the interest rate.[3]
- Cap rate above the loan constant: positive leverage. Each borrowed dollar earns more than it costs, so cash-on-cash rises above the cap rate.
- Cap rate below the loan constant: negative leverage. Borrowing pulls cash-on-cash below the cap rate, and more debt makes it worse.
In the example, a 30-year loan at 5% has a loan constant of 6.44%, below the 7.00% cap rate, so leverage is positive. At 6.5% the constant is 7.58% and at 7.5% it is 8.39%, both above the cap rate, so the same 75% loan becomes negative leverage.
Which one to use
- Pricing a property or comparing two buildings: cap rate. It removes financing so you compare the buildings, not the buyers. Values are set by dividing NOI by a market cap rate drawn from comparable sales.[2]
- Deciding how to finance, or comparing with other uses of your cash: cash-on-cash.
- Checking whether a lender will make the loan: neither. Lenders use the debt service coverage ratio, NOI (after reserves) divided by debt service.[4]
What neither one tells you
Both measures look at a single year. Neither considers later years' cash flows or the proceeds of a sale, so neither is a full measure of return.[1] Loan paydown, appreciation (or depreciation in value), income tax and the timing of cash all sit outside them. For that, use an internal rate of return over the holding period on the investment property calculator.
Try itRun your own numbers on the cap rate calculator and the cash-on-cash return calculator, or see both together on the rental property calculator.
Frequently asked questions
Is cash-on-cash return higher than cap rate?
Only with positive leverage, when the property earns more than the loan costs. With an expensive loan, cash-on-cash is lower than the cap rate.
What is the difference between cap rate and cash on cash return?
Cap rate divides NOI by price and ignores financing. Cash-on-cash divides cash flow after mortgage payments by the cash you invested, so it changes with the loan.
What is the difference between cap rate and ROI?
Cap rate is one year of NOI over the price, with no loan. ROI usually means total profit on your own cash over the whole holding period, including loan paydown and the sale.
Cap rate vs IRR: which should I use?
Use cap rate to price a property on one stabilized year. Use IRR to compare investments over several years, because it counts every cash flow and when it arrives.
Which is better for evaluating a rental property?
Use cap rate to judge the property and its price, and cash-on-cash to judge your financing and your return on cash. Use DSCR for the lender's view and IRR for the whole holding period.