Financial Intelligence
Cap rate and cash-on-cash return: real estate investment analysis.
Cap rate tells you the unlevered return. Cash-on-cash return tells you what your actual equity is earning. Both are required to evaluate an investment.
Net operating income (NOI)
NOI = Gross rent − Vacancy allowance − Operating expenses
Operating expenses include
- — Property taxes
- — Insurance
- — Maintenance
- — Property management
- — Utilities (if owner-paid)
- — Reserves for capital expenditure
Do not include
- — Mortgage payments
- — Depreciation
- — Income taxes
Cap rate
Cap rate = NOI ÷ Purchase price (expressed as %)
The cap rate is the unlevered return — it ignores financing. It is used to compare properties across different financing structures.
| Property type | Typical cap rate |
|---|---|
| Class A urban | 3% – 5% (expensive markets, low risk premium) |
| Class B suburban | 5% – 7% |
| Class C workforce housing | 7% – 10% |
| Commercial / retail | 5% – 8% |
| Industrial | 4% – 7% |
Cash-on-cash return
Cash-on-cash = Annual cashflow ÷ Total cash invested
Annual cashflow = NOI − Annual debt service (mortgage payments)
This is your actual equity return. A property with a 6% cap rate and 7.5% mortgage rate may produce negative cashflow — negative cash-on-cash — on a leveraged basis.
Debt service coverage ratio (DSCR)
DSCR = NOI ÷ Annual debt service
| DSCR | Interpretation |
|---|---|
| DSCR > 1.25 | Standard lender minimum |
| DSCR > 1.5 | Comfortable cushion |
| DSCR < 1.0 | Property does not cover its debt — negative cashflow |
The cap rate / interest rate relationship
When cap rates compress below interest rates, positive leverage disappears. You pay more in debt service than the property generates in NOI. This environment (2022–2024) made previously-cash-flowing properties technically unprofitable without significant appreciation.
Gross rent multiplier (GRM)
GRM = Purchase price ÷ Annual gross rent
Lower GRM = better value. Use GRM as a quick screen before calculating full NOI. GRM ignores operating expenses, so it is not a substitute for cap rate analysis.
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