Cap Rate vs. Cash-on-Cash Return for Rental Properties

The two formulas side by side

Both measures start from net operating income, but they divide by different things and treat the loan differently.

Finance writers describe cap rate as unlevered, meaning financing does not change it, and cash-on-cash return as levered, meaning the amount of debt does change it.

Step one for both: net operating income

Net operating income is the rent and fees you collect in a year minus the costs of running the property, with the mortgage, depreciation and income tax left out.

For a short-term rental, running costs are heavier than for a long-term lease. Our cap rate calculator lists the ones to include: property taxes, insurance, utilities and internet, cleaning, supplies, repairs and maintenance, management and platform fees, HOA dues and licenses. The calculator works it out in three lines:

1. Effective gross income = gross income × (1 − vacancy).
2. Net operating income = effective gross income − operating costs.
3. Cap rate = net operating income ÷ purchase price.

If your gross income figure already reflects real occupancy, set vacancy to zero so you don't count empty nights twice.

A worked Example

The clearest way to see the difference is to run one invented property through both formulas.

Now change only the financing and watch what moves.

The cap rate never changes, because the property is the same. Cash-on-cash return moves with every change to the loan.

When borrowing helps and when it hurts

Borrowing raises cash-on-cash return only when the property earns more on its total cost than the loan costs each year, principal included.

In the Example, cash-on-cash return is lower with the loan than buying with cash, even though the 8.50% cap rate is above the 7% interest rate. Two things explain it:

• Total cost, not price. Closing and furnishing add $55,000, so net operating income on the full $655,000 is about 7.8%, not 8.5%.
• The yearly payment includes principal. On a 30-year loan at 7%, a year of payments is about 8% of the loan amount, above the interest rate itself.

When the property earns less on its total cost than that yearly payment rate, every extra dollar borrowed lowers your cash return. When it earns more, borrowing lifts it. Paying down principal does build equity, which cash-on-cash return doesn't count, but the cash in your pocket each year is lower.

Common mistakes with both ratios

Most errors come from the inputs, not the math, so check these before you compare two deals.

• Using the list price for one home and the offer price for another. Compare like with like, and rerun the numbers at the price you actually expect to pay.
• Mixing gross and net income. Cap rate uses net operating income. Dividing gross rent by price gives a much larger number that means something else.
• Counting the mortgage in net operating income. The loan belongs in cash-on-cash return, not in the cap rate. Put it in both and the property looks worse than it is.
• Leaving out reserves and repairs. Roofs, water heaters, decks and furniture wear out faster with frequent guests. Set aside a share of revenue every year.
• Comparing across markets on cap rate alone. A higher cap rate in one city can reflect higher risk, a weaker season or tighter local rules. Cap rate works best for similar homes in the same market.
• Ignoring the property tax reset. In many counties the tax bill changes after a sale. Use the bill a new owner will pay, not the seller's.

Why short-term rentals need extra care with both numbers

Short-term rentals have more moving parts than long-term leases, so small input mistakes move both ratios a lot.

• Turnover costs. Every stay brings cleaning, laundry and supplies. Large group homes earn more per night but cost more per turnover.
• Furnishing. Beds and linens for every room, a stocked kitchen, outdoor furniture and smart locks are cash you put in. Leave them out and cash-on-cash return is overstated.
• Seasons. An annual cap rate can hide months when the home loses money. A yearly average says nothing about cash in February.
• Management. Our deal analyzer notes that full-service managers often charge 15% to 30% of booking revenue. If you self-manage, your time is a real cost even if it isn't in the formula.

For a seasonal home, run the whole deal in the deal analyzer, which shows cap rate, cash-on-cash return and DSCR together with a month-by-month view and a stress test. Our step-by-step guide on how to analyze a short-term rental deal walks through it.

What neither number tells you

Neither ratio covers taxes, appreciation, risk or whether a lender will make the loan, so use them with other checks.

For lender ratios, see our DSCR calculator and the guide to DSCR loans for short-term rentals. For local rules, see what owners should check on short-term rental permits.

This is general information, not tax, legal or investment advice. Talk to a CPA, lender or attorney about your own situation. If you want to learn about investing in large group homes with JekkyStay, see our investor page.

The bottom line

Cap rate tells you what a property earns before the loan, so it is the fair way to compare similar homes. Cash-on-cash return tells you what your own cash earns with the financing you will actually use. Calculate both from real net operating income, count furnishing and closing in the cash you put in, and remember that borrowing helps only when the property earns more on its total cost than the loan costs each year.