Cap Rate vs. Cash-on-Cash Return: Two Numbers, Two Questions
Cap rate and cash-on-cash return often get quoted interchangeably, but they answer completely different questions about a short-term rental deal.
Two ratios, two denominators
Cap rate = NOI ÷ purchase price. Cash-on-cash return = annual net cash flow ÷ cash invested (down payment + closing costs). The numerators are related (cash flow is just NOI minus debt service), but the denominators are entirely different (price vs. your actual out-of-pocket cash).
Cap rate answers "how does this property perform on its own"
Because it ignores financing entirely, cap rate is the right number for comparing two properties as assets, independent of how either would actually be financed. It’s also the number that’s most comparable across an all-cash buyer and a heavily-leveraged buyer looking at the same listing.
Cash-on-cash answers "how does this deal perform for me"
Leverage changes cash-on-cash return dramatically even though it doesn’t change cap rate at all. The same property financed at 25% down vs. purchased all-cash can show very different cash-on-cash numbers because the "cash invested" denominator shrinks so much, even though NOI and cap rate are identical either way.
This is also why cash-on-cash return can be negative even on a property with a healthy positive cap rate. High leverage plus a high interest rate can push debt service past NOI, turning positive NOI into negative cash flow relative to a much smaller cash base.
Using both together, not picking one
A strong cap rate with weak cash-on-cash usually means the deal is fine but the financing terms aren’t. It’s worth shopping the loan or increasing the down payment. A weak cap rate with a strong cash-on-cash number (from heavy leverage on a low-yield property) is a much riskier setup, since it depends on financing conditions staying favorable and offers little cushion if rates or costs rise.
FAQ
- Which number should I use to compare two different properties?
- Use cap rate for an apples-to-apples comparison of the underlying asset, then check cash-on-cash return for each under your actual expected financing, since a property can look worse on cap rate but better on cash-on-cash (or vice versa) depending on how each would be financed.
- Why is my cash-on-cash return so much higher than my cap rate?
- That’s the effect of positive leverage. When the property’s cap rate exceeds your mortgage interest rate, borrowing amplifies your return on the cash you actually put in. It reverses (cash-on-cash falls below cap rate) when the interest rate exceeds the cap rate.
- Does an all-cash purchase make cash-on-cash return meaningless?
- Not meaningless, but it converges toward cap rate. With no debt service, cash invested is just the purchase price plus closing costs, so cash-on-cash return ends up close to (slightly below, because of closing costs) the cap rate.