What Is Cap Rate?
Capitalization rate (cap rate) measures the rate of return on a real estate investment based on the income the property generates, independent of financing. It represents what your return would be if you purchased the property with all cash.
Net Operating Income (NOI) is the annual rental income minus all operating expenses (property taxes, insurance, maintenance, property management, vacancy allowance) but before mortgage payments. A higher cap rate indicates a higher return relative to the property's price, but also typically signals higher risk or a less desirable location.
Cap Rate = Net Operating Income (NOI) / Property Value x 100Cap Rate Calculation
What Is Cash-on-Cash Return?
Cash-on-cash return measures the annual return on the actual cash you have invested in a property. Unlike cap rate, it accounts for financing and shows you the return on your down payment and out-of-pocket costs.
Total cash invested includes your down payment, closing costs, and any rehab costs paid out of pocket. Annual cash flow is your NOI minus annual mortgage payments (principal and interest). Because leverage amplifies returns, cash-on-cash return is typically higher than cap rate when using a mortgage with favorable terms.
Cash-on-Cash Return = Annual Pre-Tax Cash Flow / Total Cash Invested x 100Cash-on-Cash Return Calculation
When to Use Cap Rate vs Cash-on-Cash Return
Use cap rate when comparing properties against each other, evaluating a market's overall attractiveness, or analyzing a deal without considering financing. Cap rate strips out the financing variable and lets you compare the underlying investment quality of different properties on equal footing.
Use cash-on-cash return when evaluating the actual return on your investment dollars, comparing different financing structures for the same property, or deciding between multiple investment opportunities where your cash is limited. Cash-on-cash return tells you how hard your actual money is working.
What Are Good Cap Rates and Cash-on-Cash Returns?
Good numbers vary by market, property class, and risk tolerance. Here are general benchmarks for residential investment properties:
- Cap rate 4-5%: Typical for Class A properties in major metros (low risk, low return, strong appreciation potential)
- Cap rate 6-8%: Typical for Class B properties in secondary markets (moderate risk and return)
- Cap rate 8-12%: Typical for Class C properties or tertiary markets (higher risk, higher cash flow)
- Cash-on-cash return 8-12%: Generally considered good for a leveraged rental property
- Cash-on-cash return 12%+: Excellent, often achieved through BRRRR or value-add strategies
Why Both Metrics Can Be Misleading
Cap rate does not account for financing, appreciation, tax benefits, or principal paydown. A property with a low cap rate might still be an excellent investment if it appreciates significantly or offers substantial tax advantages.
Cash-on-cash return can be inflated by high leverage. A property financed with 95% debt will show a very high cash-on-cash return in good times but carries significantly more risk if the market declines or a vacancy occurs. Always evaluate risk alongside return.
According to the U.S. Census Bureau, rental vacancy rates averaged 6.6% nationally in 2025, but this varies dramatically by market. A realistic vacancy assumption (5-10%) is critical for accurate cap rate and cash-on-cash calculations.
Key Takeaways
- Cap rate measures property-level returns independent of financing
- Cash-on-cash return measures the return on your actual invested cash
- Use cap rate to compare properties; use cash-on-cash to evaluate your personal return
- Good cap rates range from 5-10% depending on market and property class
- Good cash-on-cash returns are 8-12%+ for leveraged residential investments
Frequently Asked Questions
What is a good cap rate for rental property?
A good cap rate depends on the market and property class. In major metros, 4-6% is typical. In secondary and tertiary markets, 6-10% is common. Generally, investors should target a cap rate that exceeds their cost of capital and compensates for the level of risk. According to NCREIF, the national average for residential investment properties has been 4-8% over the past decade.
Can cash-on-cash return be higher than cap rate?
Yes, and it usually is when you use leverage (a mortgage). This is because you are earning returns on the full property value while only investing a fraction of it in cash. For example, a property with a 7% cap rate might produce a 12% cash-on-cash return when financed with a 75% LTV mortgage at a favorable rate. This leverage effect is one of the primary advantages of real estate investing.
Is cap rate or cash-on-cash return more important?
Neither is universally more important; they answer different questions. Cap rate is better for evaluating and comparing properties on an apples-to-apples basis. Cash-on-cash return is better for evaluating your personal investment returns and comparing opportunities for your limited capital. Most experienced investors analyze both metrics for every deal.