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Understanding Rental Property Returns: Cap Rate vs. Cash-on-Cash

Evaluating a rental property investment requires looking at several different return metrics, each telling you something different about the deal. The two most important are the cap rate and the cash-on-cash return.

What Is Cap Rate?

The capitalization rate (cap rate) measures a property's return independent of financing. It is calculated as:

Cap Rate = Net Operating Income (NOI) ÷ Purchase Price

A higher cap rate means a higher return relative to the property price. Cap rates typically range from 4% to 10% depending on the market, property type, and risk level. A 5-6% cap rate is common in stable metropolitan areas, while 8-10% may be found in higher-risk or secondary markets.

What Is Cash-on-Cash Return?

Cash-on-cash return measures the annual return on the actual cash you invested (down payment, closing costs, renovation). Unlike cap rate, it accounts for mortgage leverage:

Cash-on-Cash = (NOI - Annual Mortgage Payments) ÷ Total Cash Invested

Because leverage amplifies returns, your cash-on-cash return can be significantly higher or lower than the cap rate. A good cash-on-cash return for a rental property is generally 8-12% or higher.

What Makes a Good Rental Investment?

• Positive cash flow: The property should produce income after all expenses and mortgage payments. Even a small positive cash flow means the property is self-sustaining.
• The 1% rule: A quick screening rule says monthly rent should be at least 1% of the purchase price. A $200,000 property should rent for at least $2,000/month.
• Cap rate above 5%: While market-dependent, a cap rate above 5% generally indicates a reasonable return.
• Location fundamentals: Population growth, job market, school quality, and crime rates all affect long-term appreciation and rental demand.
• Built-in equity: Buying below market value or adding value through renovation creates immediate return.

Do Not Forget These Hidden Costs

New investors often underestimate vacancy (budget 5-10% of gross rent), maintenance (1% of property value per year is a common rule), and capital expenditures (roof, HVAC, appliances that need replacement every 10-20 years). Property management fees of 8-12% are another significant cost if you do not plan to self-manage.