What cash-on-cash return measures
Cap rate describes a property as if it were bought without a loan. Most apartment buildings are financed, so investors also want to know the return on the cash they actually invested. Cash-on-cash return answers that for a single year, using cash flow before income taxes.
Because it includes financing, the same building can produce very different cash-on-cash returns for different buyers. A larger loan or a lower interest rate raises the return on a smaller amount of cash; a smaller loan or a higher rate lowers it.
The formula
Cash-on-cash return equals annual pre-tax cash flow divided by total cash invested, shown as a percentage.
- Annual pre-tax cash flow = net operating income − annual debt service (principal and interest).
- Total cash invested = down payment + closing costs + upfront rehab or capital work paid in cash.
- Cash-on-cash return = annual pre-tax cash flow ÷ total cash invested × 100.
A worked example
An investor buys a building for $2,000,000 with 25% down, or $500,000. Closing costs are $40,000 and an initial rehab of vacant units costs $60,000, so total cash invested is $600,000.
The building produces $150,000 in NOI. The loan payments total $108,000 a year, leaving pre-tax cash flow of $42,000. Cash-on-cash return is $42,000 ÷ $600,000 = 7%.
How to read the result
Compare the result with what the same cash could earn elsewhere at a similar level of risk and effort. If cash-on-cash return is below the property’s cap rate, the loan is costing more than the building earns on each borrowed dollar, which is known as negative leverage. That can still make sense when you expect income to grow, but it should be a conscious choice.
Cash-on-cash return is a one-year snapshot. It leaves out principal paydown, appreciation and tax benefits, and it does not account for the timing of cash flows over a hold period. For a full picture, pair it with a multi-year projection or an internal rate of return.
Common mistakes
These errors make returns look better than they are.
- Leaving closing costs or rehab out of cash invested.
- Using interest-only payments when the loan will amortize after a short period.
- Starting from a seller’s NOI without adjusting taxes, insurance and management to your ownership.
- Ignoring capital reserves, which come out of cash flow even though they are not in NOI.
- Using stabilized NOI for a building that will take a year or more to lease up.