PROPERTY GUIDE
Cap Rate vs. Cash-on-Cash Return
Cap rate evaluates property operations before financing; cash-on-cash return measures the return on cash invested after debt service.
Capitalization rate is calculated by dividing annual net operating income by property value or purchase price. Net operating income generally includes recurring property income less operating expenses, before mortgage payments, income taxes, depreciation and major capital expenditures. This makes cap rate useful for comparing properties without allowing financing structure to dominate the comparison.
Cash-on-cash return
Cash-on-cash return divides annual pre-tax cash flow by the cash invested. Cash invested can include the down payment, closing costs and initial repairs. Because mortgage payments are included in cash flow, two buyers can obtain different cash-on-cash returns for the same property.
Use both metrics
Cap rate helps test the property’s operating economics. Cash-on-cash return helps test the investor’s financing and equity strategy. Neither metric captures every risk, so also review vacancy, lease rollover, repairs, capital reserves, debt terms and realistic exit costs.