Overview of Key Metrics
When deciding if a rental property is a good investment, four metrics provide a comprehensive picture of potential returns:
| Metric | What It Measures | Time Horizon | Best For |
|---|---|---|---|
| Cap Rate | Property's income yield relative to price (ignoring financing) | Year 1 only | Quick property comparison, market analysis |
| Cash on Cash Return | Year 1 cash flow relative to your cash invested (with financing) | Year 1 only | Understanding leveraged first-year returns |
| Annual Return | Annualized return on investment considering all cash flows | Full investment period | Single percentage comparable to stocks, bonds, and other investments |
| Cash Multiple | Total cash returned vs. cash invested | Full investment period | Understanding total wealth creation |
Cap Rate
What is Cap Rate?
The Capitalization Rate (Cap Rate) measures a property's potential return based on its first-year income, independent of financing. It answers: "What percentage return would I get if I paid all cash?"
Why Cap Rate Matters
- Financing-independent: Allows comparison across properties regardless of loan terms
- Market indicator: Cap rates vary by market, property type, and risk level
- Quick assessment: Easy to calculate for initial property screening
The Formula
Where: NOI = Annual Rental Income − Annual Operating Expenses (excludes mortgage)
What's Included in NOI
Income:
- Gross rental income (monthly rent × 12)
- Minus vacancy loss
Operating Expenses (subtracted):
- Property taxes, Insurance
- Maintenance, HOA fees
- Property management, Vacancy
NOT included in NOI: Mortgage payments, Depreciation, Income taxes, Capital expenditures
Cap Rate Example
Result: 6.80% Cap Rate — $20,400 / $300,000 × 100
What is a Good Cap Rate?
| Cap Rate | Market Interpretation |
|---|---|
| 3-5% | Premium markets (NYC, SF), lower risk, lower cash returns |
| 5-7% | Solid markets, balanced risk/return |
| 7-10% | Higher yield markets, potentially higher risk |
| 10%+ | High-risk areas or distressed properties |
Cash on Cash Return
What is Cash on Cash Return?
Cash on Cash Return (CoC) measures your first-year annual return based solely on the actual cash you invested. Unlike Cap Rate, it accounts for mortgage payments. Unlike Annual Return (IRR), it only looks at Year 1.
Why It Matters
- Measures leveraged returns: Shows how your borrowed money is working for you
- Quick annual yield: Easy to compare with savings accounts, bonds, or dividend yields
- First-year reality check: Shows your actual pocket money in Year 1
The Formula
Where: Year 1 Cash Flow = Annual Rent − Annual Expenses − Annual Mortgage Payments
Initial Cash Investment = Down Payment + Closing Costs
Cash on Cash vs Cap Rate
| Aspect | Cap Rate | Cash on Cash |
|---|---|---|
| Includes Mortgage? | No (NOI-based) | Yes |
| Shows Leverage Effect? | No | Yes |
| Denominator | Property Value | Your Cash Investment |
| Best For | Property comparison | Return on your cash |
Example
Result: 3.40% Cash on Cash Return — $2,196 / $64,500 × 100
This means for every $100 of your cash invested, you're earning $3.40 in Year 1 cash flow — similar to a dividend yield.
What is a Good Cash on Cash Return?
| CoC Return | Interpretation |
|---|---|
| 0-4% | Lower returns, common in appreciating markets |
| 4-8% | Solid cash flow, balanced investment |
| 8-12% | Strong cash flow, may indicate higher risk or great deal |
| 12%+ | Exceptional, verify assumptions carefully |
Annual Return
What is Annual Return?
Annual Return is calculated using the Internal Rate of Return (IRR) method — the annualized rate of return that makes the Net Present Value (NPV) of all cash flows equal to zero. This is the same calculation as Excel's XIRR function.
Why Annual Return Matters
- Accounts for the time value of money (a dollar today is worth more than a dollar tomorrow)
- Includes all cash flows: initial investment, ongoing cash flows, and sale proceeds
- Provides a single percentage comparable to other investments (stocks, bonds, other properties)
This is sometimes called the annualized return on investment or real estate IRR.
The Formula
Annual Return is the rate r that satisfies:
Where: CFt = Cash flow at time period t, r = Monthly rate (annualized × 12), t = Months from start
Cash Flow Components
Month 0 (Purchase):
Months 1 through N-1 (Operating Period):
Month N (Sale):
Where: Net Sale Proceeds = Appreciated Property Value − Broker Commission − Remaining Mortgage Balance
Example
For a $300,000 property with 6.5% mortgage and $200/month HOA:
- Initial investment: −$64,500 (down payment + closing costs)
- Monthly cash flows: Starting at +$183/month, growing over time
- Final month: Monthly cash flow + $213,966 (net sale proceeds)
Result: 16.40% Annual Return — monthly rate × 12
Cash Multiple
What is Cash Multiple?
The Cash Multiple, also known as Equity Multiple, measures how many times your initial cash investment is returned over the entire holding period.
Why It Matters
- Simple wealth metric: Shows total cash-on-cash wealth creation
- Intuitive understanding: "I invested $65,000 and got back $150,000 = 2.3×"
- Complements Annual Return: Annual Return tells you the rate, multiple tells you the magnitude
The Formula
Where: Total Cash Returned = Sum of All Cash Flows + Net Sale Proceeds
Interpretation
| Multiple | Meaning |
|---|---|
| < 1.0× | Loss — you got back less than you invested |
| 1.0× | Break-even — returned exactly what you invested |
| 1.5× | 50% total return over the holding period |
| 2.0× | Doubled your money |
| 3.0× | Tripled your money |
Example
Result: 4.19× Cash Return Multiple — $269,958 / $64,500; for every $1 invested, you received $4.19 back over 10 years
Operating Expenses Breakdown
Operating expenses are the ongoing costs landlords pay to own and operate a rental property. These reduce your net income and directly impact all return metrics.
1. Property Tax
- What: Annual tax levied by local government based on assessed property value
- Typical Range: 0.5% - 2.5% of property value annually (varies by location)
2. Insurance
- What: Homeowner's/landlord insurance covering property damage, liability
- Typical Range: 0.1% - 0.5% of property value annually
3. Maintenance & Repairs
- What: Ongoing upkeep, repairs, appliance replacement, landscaping
- Typical Range: 0.5% - 2% of property value annually
- Note: Older properties typically require higher maintenance budgets
4. HOA Fees
- What: Homeowner's Association fees (for condos, townhomes, planned communities)
- Typical Range: $0 - $500+ per month
- Note: HOA fees can significantly impact cash flow
5. Property Management
- What: Fee paid to professional property manager
- Typical Range: 8% - 12% of monthly rent for professional management
6. Vacancy Allowance
- What: Reserve for periods when the property is unoccupied between tenants
- Typical Range: 3% - 10% of annual rent
Total Operating Expenses
Growth Rate Assumptions
Rental property projections depend on growth rate assumptions that change values over time. Understanding these assumptions is critical for realistic projections.
1. Annual Rent Increase
- What: Expected year-over-year increase in rental income
- Default: 3% per year
- Historical Context: US rents have historically increased 2-5% annually, varying by market
2. Annual Property Appreciation
- What: Expected year-over-year increase in property value
- Default: 4% per year
- Historical Context: US home prices have averaged ~3-5% annual appreciation long-term
3. Annual Expense Increase
- What: Expected year-over-year increase in operating expenses
- Default: 2% per year
- Applies To: Property tax, insurance, maintenance, HOA, property management
Complete Numerical Example
Property Details & Assumptions
Property Details
Assumptions
Initial Investment (Month 0)
Monthly Cash Flow (Year 1)
Operating Expenses
Cash Flow Calculation
Year-by-Year Cash Flow Projection
| Year | Rental Income | Expenses | Mortgage | Net Cash Flow |
|---|---|---|---|---|
| Purchase | − | − | − | −$64,500 |
| 1 | $30,000 | −$9,600 | −$18,204 | $2,196 |
| 2 | $30,900 | −$9,807 | −$18,204 | $2,889 |
| 3 | $31,827 | −$10,019 | −$18,204 | $3,605 |
| 4 | $32,782 | −$10,235 | −$18,204 | $4,343 |
| 5 | $33,765 | −$10,456 | −$18,204 | $5,106 |
| 6 | $34,778 | −$10,682 | −$18,204 | $5,893 |
| 7 | $35,822 | −$10,913 | −$18,204 | $6,705 |
| 8 | $36,896 | −$11,149 | −$18,204 | $7,543 |
| 9 | $38,003 | −$11,391 | −$18,204 | $8,409 |
| 10 | $39,143 | −$11,637 | −$18,204 | $223,268* |
*Year 10 includes $213,966 in sale proceeds