Both numbers measure a rental's return, but they answer different questions. Cap rate looks at the property. Cash-on-cash return looks at your money.
Cap rate
Cap rate = NOI ÷ purchase price
NOI is the net operating income: rent after vacancy minus operating expenses such as taxes, insurance, maintenance and management. It does not include the loan payment, so the cap rate is the same whether you pay cash or borrow. That makes it useful for comparing properties.
Cash-on-cash return
Cash-on-cash = annual cash flow ÷ cash invested
Annual cash flow is NOI minus the loan payment. Cash invested is your down payment plus closing costs (and any rehab you pay for). Because it includes the loan, it changes with the interest rate and the down payment.
A worked example
A property costs $300,000 and has an NOI of $18,000 a year.
| Item | Result |
|---|---|
| Cap rate | $18,000 ÷ $300,000 = 6.00% |
| Loan (25% down, 7.25%, 30 years) | $225,000, payment about $1,534.90 a month, $18,418.76 a year |
| Annual cash flow | $18,000 − $18,418.76 = −$418.76 |
| Cash invested | $75,000 down + $6,000 closing = $81,000 |
| Cash-on-cash (financed) | −$418.76 ÷ $81,000 = about −0.52% |
| Cash-on-cash (all cash) | $18,000 ÷ ($300,000 + $6,000) = about 5.88% |
The cap rate is 6.00% in both cases. The cash-on-cash return changes a lot because of the loan. At that interest rate, the loan payment is higher than the NOI, so borrowing lowers the return on the cash invested.
When to use which
Use the cap rate to compare properties. Use cash-on-cash return to see what a specific deal, with its specific loan, does for your cash. Lenders also look at coverage, which you can check with the DSCR calculator.