1. Start with NOI before calculating either return
For underwriting, Net Operating Income is effective rental income after vacancy and operating expenses, before debt service and income taxes. Keep financing outside NOI so properties can be compared independently of how each buyer funds them.
Operating expenses commonly include taxes, insurance, repairs, maintenance, management, owner-paid utilities, HOA or CDD when applicable and reserves appropriate to the asset.
2. Cap rate measures the property before financing
A simple underwriting formula is Cap Rate = annual NOI ÷ acquisition basis or property value. Be consistent about the denominator when comparing deals.
Cap rate is useful for comparing operating yield, but it does not show debt service, loan costs, required cash or your actual leveraged return.
3. Cash-on-cash measures return on cash invested
Cash-on-cash return = annual pre-tax cash flow ÷ total cash invested. Cash invested can include down payment, buyer closing costs, initial repairs and other acquisition cash depending on the underwriting convention.
Because debt service is included in cash flow, two investors buying the same property can have different cash-on-cash returns.
4. Example: one property, two different questions
If a property produces $18,000 of annual NOI on a $225,000 acquisition basis, the cap rate is 8.0%. If financing and other recurring cash items leave $7,500 of annual pre-tax cash flow and the investor placed $75,000 of total cash into the deal, cash-on-cash is 10.0%.
The first metric describes the asset's operating yield; the second describes the investor's cash return under that capital structure.
5. Never underwrite from one metric
Run base, downside and upside scenarios for rent, vacancy, repairs, insurance, taxes and financing. Add liquidity reserves and capital expenditure assumptions rather than optimizing the spreadsheet to a target return.
IRS Publication 527 is useful for understanding common rental income and expense categories, but tax reporting rules are not a substitute for investment underwriting and should be confirmed with a tax professional.
Common questions
Does mortgage payment go into cap rate?
No. Standard property underwriting calculates NOI and cap rate before debt service. Financing is reflected in cash flow and cash-on-cash analysis.
Can leverage raise cash-on-cash return?
Yes, but leverage can also increase downside risk. Compare return together with debt service coverage, reserves and stress scenarios.
Should I use purchase price or all-in acquisition basis for cap rate?
Either convention can be used if stated clearly, but comparisons must use the same denominator. For value-add deals, all-in basis often provides a more decision-useful view.