Cap rate vs cash-on-cash return

These two numbers get compared as though they are rival answers to the same question. They are not. They answer different questions, and the difference between them is the loan.

One building, three returns

Here is the same property three times: bought outright, and bought with 25% down at two different interest rates. The property does not change. Its income does not change. Its cap rate does not change.

The cap rate is identical in all three columns, because nothing about the building changed. The cash-on-cash return swings from comfortably positive to negative, on identical rent and identical expenses, purely because of what the money cost.

One detail in the first column is worth pausing on: paid in cash, the cash-on-cash return comes in slightly under the cap rate rather than matching it. That is the closing costs. They are cash you invested, so they sit in the denominator of the cash-on-cash calculation — but they are not part of the purchase price, so they never touch the cap rate. Even with no loan at all, the two numbers measure from different starting points.

Why the third column loses money

The mechanism has a name, and it is worth knowing because it predicts the answer before you run any numbers. Compare two figures:

• The cap rate — what the building earns on its full value, 6.0% here.
• The loan constant — annual debt service divided by the loan amount. Not the interest rate: the rate plus the principal you are repaying, which is why the constant on a 30-year loan is always higher than its rate.

When the loan constant is below the cap rate, borrowing pays you: every dollar financed earns more in the building than it costs to service, and the return on your own cash rises above the cap rate. That is positive leverage, and it is the second column.

When the loan constant is above the cap rate, the arithmetic reverses. Each borrowed dollar costs more than it earns, and the shortfall comes out of your cash flow. That is negative leverage, and it is the third column. Leverage does not magnify returns — it magnifies whichever direction the gap already points.

Where each one misleads

Cap rate flatters a deal you cannot afford. A property with an attractive cap rate can still produce negative cash flow every month at the rate you are actually quoted. The cap rate will not tell you, because the loan is not in it. That is not a flaw — it is the definition doing its job — but it is an easy way to misread a cap rate.

Cash-on-cash flatters leverage and ignores time. It is a single-year, pre-tax cash measure. It counts none of the principal your tenant pays down, no appreciation, and no tax treatment. A heavily financed deal can post a strong first-year cash-on-cash return and still be the weaker asset, and a modest one can be the better long-term hold.

Neither number is the deal. They are two instruments reading different things, and the reason to run both is that they disagree in informative ways.

Which one to reach for