Rental Property Math: Cap Rate and Cash-on-Cash Return With a Worked Example

Step 1: Net Operating Income

NOI equals rental income minus operating expenses, excluding mortgage payments and depreciation. Suppose rent is $2,800 a month ($33,600 a year). Subtract a vacancy allowance of 5% ($1,680), property taxes ($4,200), insurance ($1,500), maintenance and repairs ($3,000, about 1% of value), property management at 8% ($2,690), and other costs. The result is approximately $21,000 of NOI. It is important to include realistic costs for vacancies, repairs, and management even if you plan to self-manage, since your time has value and costs can be lumpy.

A common rough check is the '50% rule', which assumes that operating expenses (excluding mortgage) run about 50% of gross rent. Here expenses are about 37%, which may be optimistic for an older property.

Step 2: Cap Rate

Cap rate = NOI ÷ purchase price = 21,000 ÷ 300,000 = 7.0%. It lets you compare properties on an unlevered basis: the same property would have the same cap rate whether purchased with cash or a mortgage. Markets with high prices relative to rents have low cap rates (3% to 5%), while lower-priced markets may have 7% to 10% or more, often with higher risk. A property's value can be estimated as NOI ÷ market cap rate: at a 6% market cap rate, the property above would be worth $350,000.

Step 3: Cash-on-Cash Return

Cash-on-cash = annual pre-tax cash flow ÷ total cash invested. With a $240,000 loan, the monthly payment is $1,517, or $18,204 a year. Cash flow = $21,000 − $18,204 = $2,796. The cash invested is the $60,000 down payment plus about $9,000 of closing costs: $69,000. Cash-on-cash return = 2,796 ÷ 69,000 = 4.05%. That is lower than the 7% cap rate, because the mortgage rate (6.5%) is close to the cap rate, so leverage adds little. When the loan rate is higher than the cap rate, leverage reduces returns (negative leverage).

In addition to cash flow, the investor benefits from loan paydown (about $2,700 in the first year), potential appreciation, and tax advantages such as depreciation, which are not in the cash-on-cash figure.

Common Mistakes

Ignoring vacancies and capital expenditures such as roof, HVAC, and appliances. Using the seller's optimistic income projection without verification. Forgetting closing costs and initial repairs. Confusing cap rate (unlevered) with cash-on-cash (levered). Comparing cap rates across very different markets and risk levels. Always stress test: what if rent falls 10% or vacancy doubles? At 10% lower rent, NOI would drop by about $3,360, turning the cash flow negative.

Using the Numbers

Set minimum return criteria: for example, a cap rate above the mortgage rate and cash-on-cash above 6% to 8%. Compare with alternatives such as index funds, which require no management. Real estate offers leverage and tax benefits but demands time, knowledge, and risk tolerance. Consult an accountant and inspect the property thoroughly before you buy.