Cap rate vs cash-on-cash return

One Canadian deal, two returns

Take a duplex listed at $600,000. The gross rent is $3,600 a month, and the operating costs, including property tax at the city mill rate, insurance, maintenance, management, and a vacancy reserve, come to about $1,100 a month. That leaves a net operating income near $30,000 a year.

Cap rate divides that NOI by the price: $30,000 on $600,000 is a 5.0% cap rate. Notice the mortgage never came up. Cap rate treats the deal as if you paid cash, which is exactly why it is useful for comparing two buildings. It strips out how you financed each one.

Cash-on-cash brings the mortgage back. Say you put $120,000 down plus $15,000 in closing costs, so $135,000 of your own money goes in. With a mortgage payment near $2,500 a month, your cash flow after the mortgage is about $0 a month at these numbers. Divide a small annual cash flow by $135,000 and the cash-on-cash return is close to zero, even though the cap rate looked fine.

That gap is the whole lesson. The 5% cap rate said the property earns a reasonable return. The flat cash-on-cash said the current mortgage takes most of that return before it reaches you. Both are true. You need both to see the deal clearly.

When to lean on each one

Use cap rate to compare

When you are looking at several properties, cap rate puts them on equal footing. It does not care that you would put 20% down on one and 35% on another. That makes it the right tool for ranking a shortlist or judging whether a price is fair for the income.

Use cash-on-cash to decide

Once you are serious about a specific property, cash-on-cash answers the question you actually care about: what does my money earn in year one? It folds in your down payment, your closing costs, and your real mortgage. In Toronto and Vancouver, many investors knowingly accept a thin or negative cash-on-cash because they are buying for appreciation. That can work, but cash-on-cash is the number that shows you the bet in writing.

Read them together

• Strong cap rate, weak cash-on-cash: the mortgage is heavy. A longer amortisation or more down payment may fix it.
• Weak cap rate, strong cash-on-cash: the mortgage is doing the work. Watch what happens if rates rise at renewal.
• Both weak: the deal is telling you to walk, or to find rent upside you can actually capture.

Cap rate vs cash-on-cash questions

What is the difference between cap rate and cash-on-cash?

Cap rate measures the property as if you paid all cash, so it ignores the mortgage. Cash-on-cash measures what your own money earns after the mortgage. Cap rate compares properties; cash-on-cash tells you your real first-year return.

Which one should I use?

Use both. Cap rate to compare two buildings on equal footing, and cash-on-cash to see what your down payment earns once financing is in. A high cap rate with weak cash-on-cash means the mortgage is eating the deal.

Can cap rate and cash-on-cash point in different directions?

Yes, often. A mortgage can lift cash-on-cash above the cap rate when the loan costs less than the property earns. It can also drag cash-on-cash below zero when the mortgage is heavy. Seeing both at once is how you catch that.

Does cap rate change with my down payment?

No. Cap rate is the same no matter how you finance it, because it ignores the mortgage. Cash-on-cash moves a lot with your down payment, since it is built on the cash you put in.