Two percentages come up in almost every conversation about an apartment building: the cap rate and the cash-on-cash return. They sound similar and are often quoted side by side, but they answer different questions. The cap rate describes the building. Cash-on-cash describes your investment in it, including the loan. Mixing them up is one of the easiest ways to overpay or to misjudge how much money a deal will actually put in your pocket.
The short version
| Cap rate | Cash-on-cash return | |
|---|---|---|
| Formula | NOI / purchase price | Annual pre-tax cash flow / cash invested |
| Includes the loan? | No | Yes |
| What it describes | The property’s income relative to its price | Your yearly cash return on the money you put in |
| Best used for | Comparing buildings and estimating value | Comparing financing options and your own returns |
| Changes when rates change? | Not directly | Yes, through the loan payment |
Cap rate: the building’s yield
The capitalization rate is net operating income divided by price. If a building earns $150,000 of NOI and sells for $3,000,000, its cap rate is 5%. Because it ignores financing, two buyers looking at the same building see the same cap rate whether one pays cash and the other borrows most of the price. That makes it useful for comparing buildings: brokers and appraisers look at the cap rates of recent sales of similar buildings to estimate what a property is worth.
A cap rate is only as good as the NOI behind it. A listing that quotes a cap rate on the seller’s figures may be quoting a building that does not exist once you add a management fee, a new tax assessment and a realistic vacancy allowance. Rebuild the NOI first, as described in Net Operating Income: The Number Every Apartment Deal Starts With, then calculate the cap rate yourself.
Cash-on-cash: your yield
Cash-on-cash return takes the cash flow left after the loan payment and divides it by the cash you actually invested: down payment, closing costs and any money set aside at purchase for repairs. It is the number that tells you what the deal does for you in a normal year, before taxes and before any gain on sale.
One building, two answers
Here is a made-up example. A building costs $3,000,000 and has an NOI of $165,000, a 5.5% cap rate. The buyer puts 35% down and pays $60,000 in closing costs, for $1,110,000 of cash invested. The loan of $1,950,000 at 6.5% interest on a 30-year schedule has an annual payment of about $147,900.
Cash flow is $165,000 minus $147,900, or about $17,100. Divided by $1,110,000, that is a cash-on-cash return of roughly 1.5%. The building yields 5.5%, but the buyer’s cash earns far less in year one because the loan costs more than the building yields on the borrowed part. This is sometimes called negative leverage: borrowing at a rate above the cap rate pulls cash-on-cash below the cap rate.
Change one input and the picture changes. At a 5% interest rate the same loan costs about $125,600 a year, cash flow rises to about $39,400 and cash-on-cash to roughly 3.5%. The cap rate did not move at all.
Which number should drive your decision?
If you are deciding what to offer
Lean on the cap rate, based on your own NOI and compared with sales of similar buildings nearby. Price is a property question, and the cap rate is the property’s number.
If you are deciding how to finance
Use cash-on-cash. Try several down payments, rates and loan terms and see how your yearly return changes. Pair it with the debt service coverage ratio covered in DSCR: How Lenders Size an Apartment Loan, because the lender will.
If the two tell different stories
A decent cap rate with a thin cash-on-cash return usually means the loan is expensive relative to the building’s yield. Some buyers accept that because they expect rents to grow or plan to refinance later. In Washington, rent growth on most existing units is limited each year, so check Washington’s Rent Increase Limit and What It Means for Your Projections before you count on it.
What neither number shows
Neither measure includes capital projects, appreciation, loan paydown or taxes. A building with a new roof and a building that needs one can have the same cap rate this year. That is why underwriting does not stop at two percentages: it includes a reserve for capital items and a stress test of the numbers under worse conditions.
Key takeaways
- Cap rate = NOI / price. It describes the building and ignores the loan.
- Cash-on-cash = cash flow after debt service / cash invested. It describes your money.
- When the loan rate is above the cap rate, cash-on-cash falls below the cap rate.
- Use cap rate to price, cash-on-cash to choose financing, and check both against a stress test such as the one in Stress-Testing an Apartment Deal: Rates, Rents, Expenses and Exit.