Cap rate vs cash on cash return: the difference

Cap rate vs cash on cash return comes down to one question: are you measuring the property or your money? Cap rate is net operating income divided by the property's price, so it ignores how you finance the purchase. Cash on cash return is your annual cash flow after mortgage payments divided by the cash you actually invested, so it shows what leverage does to your return. Use cap rate to compare properties and cash on cash return to compare financing options and your own investments.

The two formulas

Cap rate (capitalisation rate)

Cap rate (%) = net operating income / purchase price (or current value) × 100

Net operating income (NOI) is annual rent minus vacancy and all operating costs: maintenance, insurance, non-recoverable building costs, property taxes and management. It excludes mortgage payments and income tax.

Cash on cash return

Cash on cash return (%) = annual pre-tax cash flow / total cash invested × 100

Annual pre-tax cash flow is NOI minus all mortgage payments (interest and, for a repayment loan, principal). Total cash invested is your deposit plus purchase costs plus any money spent on initial works.

Cap rate vs cash on cash return side by side

	Cap rate	Cash on cash return
Measures	The property's income return	The return on your own cash
Numerator	Net operating income	Cash flow after mortgage payments
Denominator	Price or current value	Deposit + purchase costs + initial works
Affected by financing	No	Yes, strongly
Includes purchase costs	No	Yes
Best for	Comparing properties, rough valuation	Comparing loan structures, your actual yield on cash
Main blind spot	Ignores debt and your real outlay	Ignores principal paid down and price changes

Worked example: one property, four ways to buy it

The example uses euros; the maths works in any currency. Assume:

• Purchase price: €240,000
• Purchase costs: €19,200 (8% of the price, an example figure)
• Rent: €1,300 per month, so €15,600 per year
• Operating costs including vacancy: €4,800 per year

NOI = €15,600 − €4,800 = €10,800

Cap rate = €10,800 / €240,000 = 4.5%

The cap rate is the same no matter how you pay. Now look at four financing scenarios. The loans are 70% of the price, €168,000, at example interest rates.

Scenario	Cash invested	Annual mortgage payments	Annual cash flow	Cash on cash return
All cash	€259,200	€0	€10,800	4.17%
Interest-only at 3.5%	€91,200	€5,880	€4,920	5.39%
Interest-only at 5.5%	€91,200	€9,240	€1,560	1.71%
Repayment over 25 years at 3.5%	€91,200	about €10,090	about €710	about 0.78%

In the financed scenarios, cash invested is the €72,000 deposit plus €19,200 purchase costs.

Three lessons stand out:

1. Cheap debt raises cash on cash return above the all-cash figure. At 3.5% the investor earns 5.39% on their cash, compared with 4.17% without a loan.
2. Expensive debt drags it down. At 5.5% the return on cash falls to 1.71%, well below what the property earns unlevered.
3. A repayment loan lowers cash on cash return because principal is part of the payment. That money is not lost, as the next section shows.

You can reproduce these figures, or test your own deal, with the rental yield calculator, and see how the repayment loan's payments split between interest and principal in the mortgage calculator.

When leverage helps and when it hurts

Leverage helps when the interest rate on the loan is below the property's unlevered return. In this example, the all-cash return is €10,800 / €259,200 = 4.17%. Borrowing at less than about 4.17% interest-only raises your cash on cash return; borrowing at more lowers it.

This is often described as positive and negative leverage. Some people use the cap rate as the comparison point. That is a close approximation, but once purchase costs are included, the true break-even rate is slightly below the cap rate, as here.

Negative leverage does not automatically make a deal bad. You might still borrow because you expect growth, want to keep cash for other uses or plan to refinance. But you should know you are paying more for the money than the property earns on it. Our guide to what is a good rental yield shows a simple break-even check for both interest-only and repayment loans.

Principal repayment and total return

With the repayment loan, the year's payments of about €10,090 include roughly €4,300 of principal. Cash on cash return treats all of it as an outflow. A broader figure, sometimes called first-year return on investment, adds the equity you built:

(Cash flow + principal repaid) / cash invested = (€710 + €4,300) / €91,200 = about 5.5%

That is close to the interest-only scenario, because both loans cost roughly the same in interest in the first year. The difference is that the interest-only investor keeps the cash now, while the repayment investor keeps it as reduced debt. Which is better depends on your goals and your need for monthly income; see interest only vs repayment mortgage for the trade-offs and how mortgage amortization works for how the principal share grows each year.

Using cap rate to estimate value

Because cap rate links income and price, you can rearrange it:

Value = NOI / cap rate

If buyers in your market expect around a 4.5% cap rate on similar property, a property with €10,800 of NOI would be valued at about €240,000. If the expected cap rate were 5%, the same income would be worth €216,000.

Two points of caution:

• In many residential markets, buyers and agents talk about yields or the gross rent multiplier rather than cap rates, and prices are driven by owner-occupiers as much as investors. This method is a cross-check, not a valuation.
• Small changes in cap rate move the value a lot. Do not rely on a market cap rate unless you know exactly how it was calculated.

Which metric should you use?

• Screening listings: cap rate (or net yield) lets you compare properties fairly, regardless of how each buyer finances them.
• Comparing loan offers: cash on cash return shows how deposit size, interest rate and loan type change your return.
• Deciding whether to borrow more or less: compare cash on cash return across different loan-to-value levels. Our guide to the loan to value ratio explained covers the risks of borrowing more.
• Monthly budgeting: neither; look at rental property cash flow month by month.
• Long-term decision: combine both with a cautious assumption for growth, tax and selling costs, ideally with a tax adviser's input.

Common mistakes

• Putting mortgage payments into NOI. This turns the cap rate into a meaningless hybrid. Keep financing out of NOI.
• Forgetting purchase costs in cash invested. Your outlay is more than the deposit.
• Using the asking rent. Both metrics are only as good as the rent and cost estimates behind them.
• Treating year-one cash on cash return as permanent. Rents, costs and interest rates change, especially when a fixed rate ends.
• Comparing cap rates calculated differently. Some include management or a vacancy allowance; some do not. Ask what is in NOI.
• Ignoring risk. A higher cash on cash return from heavy borrowing also means a thinner buffer if something goes wrong.

Key takeaways

• Cap rate = NOI / price. It describes the property and ignores financing.
• Cash on cash return = cash flow after mortgage / cash invested. It describes your money.
• Borrowing below the property's unlevered return lifts cash on cash return; borrowing above it lowers it.
• Repayment loans lower cash on cash return but build equity; track that separately.
• Use both, together with a cash flow forecast and realistic assumptions.

For how these metrics fit into choosing, financing and running a rental, see our buy to let investing guide, and for the yield formulas themselves, how to calculate rental yield.