Is a rental property a good deal? Cap rate and cash flow in plain English

The property

A $250,000 rental, bought with $50,000 down and a loan for the other $200,000. It rents for $2,200 a month. The assumptions for the year:

• Vacancy of 5% (the unit is empty about 18 days a year).
• Property tax $3,000 and insurance $1,400.
• Maintenance at 8% of the rent collected and management at another 8%.
• $1,000 of other costs, and loan payments of $12,000 a year.

Step 1: the rent you really collect

$2,200 × 12 is $26,400, but the unit will not be rented every day. At 5% vacancy you collect $25,080. Maintenance and management are charged on what you collect, not on the sticker rent.

Step 2: operating costs and net operating income

• Rent collected$25,080
• Property tax− $3,000
• Insurance− $1,400
• Maintenance and management, 16% of rent− $4,013
• Other costs− $1,000
• Net operating income (NOI)$15,667

NOI is what the property earns before any loan. It is the same whether you bought with cash or borrowed everything.

Step 3: the three numbers

• Cap rate: NOI ÷ price, $15,667 ÷ $250,0006.3%
• Cash flow: NOI − loan payments, $15,667 − $12,000$3,667 a year
• Cash-on-cash: cash flow ÷ cash invested, $3,667 ÷ $50,0007.3%

They answer different questions. Cap rate ignores your loan, so it compares one property with another. Cash flow is what lands in your pocket after paying the lender. Cash-on-cash is that cash flow against the money you put in, so it compares the property with your other uses for that money. Two buyers of the same house with different deposits and interest rates share a cap rate and have very different cash-on-cash returns.

Stress test: change one thing

The base case looks fine, so see how little it takes to change it:

• Base case$3,667 · 7.3%
• Loan payments $14,400 instead of $12,000$1,267 · 2.5%
• Rent falls to $2,000 a month$1,752 · 3.5%
• Vacancy 10% instead of 5%$2,558 · 5.1%
• Maintenance 12% instead of 8%$2,664 · 5.3%

Figures are cash flow and cash-on-cash. The loan payment is the lever that matters most here: the property is exactly as good as before, and the result drops by two thirds, because the cap rate never saw the loan. Rent matters too: a $200 drop, about 9%, cuts the cash flow by more than half. That is how a deal that looked comfortable on paper turns thin.

What these numbers leave out

• Income tax. It depends on your country and your situation, so none of it is in here.
• Principal paid down and price changes. Part of every loan payment reduces what you owe, and the property may rise or fall in value. Neither is in cash flow.
• Big, irregular repairs. A roof or a boiler is not smooth 8% a year. Keep a reserve.
• Buying costs and your own time. Closing costs raise the cash you put in, and managing it yourself is not free even when you do not pay for it.

Mistakes that flatter a deal

1. Using the asking rent with no vacancy. No unit is rented 365 days a year.
2. Leaving out maintenance and management because you plan to do it yourself. Put your time in, or the deal only works while you are free.
3. Judging by cap rate alone. It says nothing about your loan, and the loan can decide the outcome.
4. Testing only the happy case. Re-run it with higher vacancy, lower rent and a higher payment before you decide.