Cap rate and cash-on-cash return show up in most rental calculators, and both are percentages, so they get treated as two ways of saying the same thing. They answer different questions.
What is cap rate?
Cap rate is a house’s yearly income after running costs, divided by its price. It leaves the mortgage out on purpose, so it comes out the same however the house is paid for.
That income after running costs has a name: net operating income, or NOI. It’s the rent, minus empty months, repairs, money set aside for big repairs, management, taxes and insurance.
What is cash-on-cash return?
Cash-on-cash return is the cash a rental puts in your pocket in a year, after the mortgage, divided by the cash you put in to buy it: the down payment, closing costs and any work up front.
Change the loan and you change both halves of that fraction.
One house, four ways to pay
Take a $250,000 house renting for $2,500 a month. After running costs, it earns $17,700 a year. Closing costs are 3% of the price.
| Cap rate | Cash-on-cash | |
|---|---|---|
| All cash | 7.1% | 6.9% |
| 25% down at 6% | 7.1% | 6.0% |
| 20% down at 7% | 7.1% | 3.0% |
| 20% down at 8% | 7.1% | 0.2% |
The cap rate never moves, because the house never changed. Cash-on-cash moves with every loan. At 8% interest the mortgage takes almost all of the $17,700, so the cash you put in earns almost nothing.
Here’s where two of those cash-on-cash numbers come from:
| All cash | 20% down at 7% | |
|---|---|---|
| Income after running costs | $17,700 | $17,700 |
| Mortgage payments for the year | $0 | −$15,967 |
| Cash flow for the year | $17,700 | $1,733 |
| Cash you put in | $257,500 | $57,500 |
| Cash-on-cash return | 6.9% | 3.0% |
Which one should you use?
Use cap rate to compare houses. It takes the loan out, so houses at different prices can be judged on the same terms.
Use cash-on-cash to decide whether a deal is worth your money. It’s the one that includes your loan, so it can tell you that a good house is a poor deal at the rate you can get.
Neither one shows how many dollars a house pays you each month. At 20% down and 7%, this house earns a 3.0% cash-on-cash return, which works out to $144 a month. For what that thin margin looks like next to a house that loses money, see the 1% rule example.
Why do cap rates differ between calculators?
Often because they count different running costs. DealLevel counts money set aside for big repairs, like a roof or a furnace, as a running cost. A calculator that leaves it out shows a higher cap rate for the same house, so check what’s included before you compare a cap rate from one source with another.
The definitions in Help spell out what DealLevel’s numbers include.