Cap rate vs. cash-on-cash return, explained with one example

These two metrics get confused constantly, because they both describe how well a property performs — but they answer different questions, and can point in opposite directions on the exact same deal.

The example

Say you’re looking at a $400,000 property with $28,000 a year in net operating income (NOI) — rent after vacancy and operating expenses, before any mortgage payment.

Cap rate asks: if I paid all cash, what return would this income generate? That’s simply $28,000 ÷ $400,000 = 7%. It doesn’t matter how you actually plan to pay for the property — cap rate assumes an all-cash buyer every time.

Cash-on-cash return asks a completely different question: given how I’m actually financing this, what return am I getting on my actual cash? Say you put 25% down ($100,000) plus $8,000 in closing costs — $108,000 of your own cash. Your 30-year mortgage on the remaining $300,000, at about 4.85%, costs $19,000 a year in principal and interest. Your actual cash flow is $28,000 − $19,000 = $9,000. Cash-on-cash return is $9,000 ÷ $108,000 = 8.3%.

Same property, same income — a 7% cap rate and an 8.3% cash-on-cash return. The gap is entirely explained by leverage.

Why leverage can cut both ways

In the example above, borrowing helped, because the property’s return (its cap rate) exceeded the effective cost of the mortgage. When that relationship flips — when the loan’s yearly payments, as a share of the amount borrowed, cost more than the cap rate — leverage works against you, and cash-on-cash return drops below cap rate instead of rising above it. This is the single most important intuition to build about leveraged real estate: debt amplifies whatever the underlying deal was already doing, for better or worse.

Run the same deal with a 7.5% mortgage rate instead. The $300,000 loan now costs about $25,170 a year over 30 years. Cash flow falls to $28,000 − $25,170 = $2,830, and cash-on-cash return falls to $2,830 ÷ $108,000 = 2.6%. The property did not change and its cap rate is still 7% — only the price of the borrowed money did.

The break-even test: cap rate vs. loan constant

There is a quick way to tell in advance which side of the line a deal falls on. Divide the annual mortgage payment by the loan amount. Lenders call this the loan constant, and it captures both the interest rate and the speed of repayment.

In the first version of the example, $19,000 ÷ $300,000 is a loan constant of about 6.3%, below the 7% cap rate, so the borrowed money earns more than it costs and leverage lifts cash-on-cash return. At a 7.5% rate the loan constant is about 8.4%, above the cap rate, so borrowing drags the return down. If the cap rate is higher than the loan constant, debt helps; if it is lower, debt hurts.

Note that this is not the same as comparing the interest rate with the cap rate. At 6.5%, still below the 7% cap rate, a 30-year loan already has a loan constant of about 7.6%, so the same deal would earn only about 4.9% cash-on-cash.

What cash-on-cash return leaves out

Cash-on-cash return only counts money that lands in your account each year. Part of every mortgage payment repays principal, which builds equity even though you never see it as cash. The property may also rise or fall in value, and tax rules on depreciation and interest can change what you keep. None of these appear in either metric.

That is why a deal with a modest cash-on-cash return can still be a reasonable long-term investment, and why a high one is not automatically safe. If you want all the sources of return in one place — cash flow, principal paydown, and appreciation — you need a total-return view rather than either single ratio.

What cap rate leaves out

Cap rate has blind spots of its own. It is a snapshot of one year’s income, so it says nothing about rent growth, upcoming repairs, or a lease that ends next month. It also depends entirely on how NOI was calculated. A seller who leaves out vacancy or maintenance can make any property look like a high cap rate, which is why it pays to rebuild the NOI yourself rather than trust the one in the listing.

Which one should you use?

Use cap rate to compare properties or markets independent of financing — it’s the cleaner apples-to-apples metric. Use cash-on-cash return to judge how a specific deal will perform with your specific loan terms, which is what actually determines your annual cash flow. Serious investors track both, on the same deal, side by side.

A sensible order is to screen with cap rate first, because it tells you whether the property itself earns enough, then check cash-on-cash return with the loan you can actually get. A property that only works because of cheap or unusual financing deserves a second look before you commit.

For more on judging the first number, read what is a good cap rate? Then try it yourself with the cap rate calculator and the cash-on-cash return calculator — or run the full picture at once in the property investment calculator.