Cap Rate vs Cash on Cash Return: One Duplex, Both Numbers

Two numbers, two different questions

Cap rate and cash on cash return get used interchangeably in listing descriptions, forum posts, and unfortunately in purchase decisions. They are not interchangeable. Cap rate asks: what does this property yield on its full price, ignoring financing entirely? Cash on cash asks: what does the actual cash I pulled out of my bank account earn this year, after the mortgage is paid? One grades the property. The other grades your position in it.

I learned the difference the embarrassing way. On my first duplex I proudly quoted my levered return to a friend who owned his building free and clear, compared my number to his cap rate, and concluded I was the sharper investor. I was comparing a financed return against an unlevered one, which is like comparing your sprint time downhill to his on flat ground. This post is the explanation I wish someone had made me sit through, with one duplex computed both ways so the difference is visible instead of theoretical.

The duplex we will beat to death

The building: a $300,000 duplex, both units renting at $1,400 a month. Gross scheduled rent is $33,600 a year. Take 5% vacancy, $1,680, and effective gross income is $31,920.

Operating expenses: property taxes $3,720, insurance $1,800, management $2,400, repairs $2,400, capital reserve $1,500, and $600 of miscellaneous. Total: $12,420. Net operating income is $31,920 minus $12,420, which is $19,500.

Cap rate is NOI over price: $19,500 divided by $300,000 equals 6.5%. That is the property's unlevered yield, and it will not change no matter how we finance the purchase. You can verify every line in the cap rate calculator, and I wrote a full walkthrough of what that 6.5% does and does not mean in what is a good cap rate.

Scenario one: paying all cash

Buy the duplex outright with $300,000 plus about $6,000 in closing costs, so $306,000 of cash invested. With no mortgage, annual cash flow equals NOI: $19,500. Cash on cash return is $19,500 divided by $306,000, which is 6.37%.

Notice that is almost the cap rate, just shaved slightly by closing costs. That is not a coincidence, it is the definition: with no debt, cash on cash and cap rate are nearly the same number. Which means the only reason to compute both is leverage. So let us add some.

Scenario two: 25% down at 7%

Same duplex, now with a $75,000 down payment and a $225,000 loan at 7% over 30 years. Monthly principal and interest come to about $1,497, which is roughly $17,963 a year. Annual cash flow is $19,500 of NOI minus $17,963 of debt service: $1,537.

Cash invested is the $75,000 down payment plus about $9,000 of closing and lender costs, $84,000 total. Cash on cash return: $1,537 divided by $84,000 equals 1.83%.

Sit with that. The identical building that yields 6.5% unlevered pays the financed buyer 1.83% on their cash, before a single surprise repair. The cap rate did not lie, and neither did the loan. Leverage simply took a modest yield and handed most of it to the lender. Run your own version in the cash on cash return calculator before trusting anyone's pro forma, including mine.

The loan constant, or when leverage flips the answer

Here is the rule underneath the example. Divide annual debt service by the loan amount and you get the loan constant: $17,963 over $225,000 is 7.98%. Compare that to what the property yields. When the loan constant is higher than the yield, every borrowed dollar costs more than it earns, and leverage drags your return down. That is negative leverage, and at a 7% interest rate against a 6.5% cap, it is exactly what we got.

Now rerun the loan at 5%, which I will label plainly as an illustrative rate, not a quote. The payment falls to about $1,208 a month, $14,494 a year, a loan constant of 6.44%. Cash flow rises to $5,006, and cash on cash becomes $5,006 over $84,000, which is 5.96%. Better, dramatically so, but notice it still trails the 6.37% all-cash figure, because the constant still sits a hair above the deal's yield on total cost. Leverage only genuinely amplifies returns once the constant drops below what the property earns, and every fraction of spread beyond that point works in your favor.

This is why the same duplex can be a reasonable purchase for a cash buyer and a poor one for a financed buyer in the same week. When I am comparing loan offers, I compute the constant for each one in the loan comparison tool, because two loans with similar rates but different terms can sit on opposite sides of that line.

What each metric is actually for

Use cap rate to evaluate and compare properties: is this building priced sensibly against its peers, and how sensitive is that price to market shifts? Use cash on cash to evaluate your deal structure: given this loan, this down payment, and these costs, does the return on my actual cash justify tying it up here rather than anywhere else?

And keep both metrics honest about what they omit. Neither one sees principal paydown, appreciation, or tax treatment, which are real components of total return. Cash on cash in particular can look terrible in year one on a deal that is excellent over ten years, and can look great on an interest-only structure that is quietly building no equity at all. Investors who finance rentals on debt-service based loans get graded on a third, related number, which I cover in DSCR loans explained.

The two-number habit

My rule now is mechanical. Every deal gets both numbers, always in the same order. Cap rate first, to judge the building and the price. Cash on cash second, to judge the structure I am wrapping around it. If the cap rate is fine but the cash on cash is ugly, the problem is my financing, not the property, and the fix is a different loan or a bigger down payment, not a different house. If both are ugly, the price is wrong.

Standard caveat, sincerely meant: this is arithmetic on stated assumptions, not financial advice. Rates, rents, and expenses move, and the spreadsheet does not know your situation. But the relationships in this post, cap rate to property, cash on cash to structure, and the loan constant deciding which way leverage cuts, those hold everywhere.