Rental income looks straightforward until you actually run the numbers: mortgage, taxes, insurance, maintenance, vacancy, and management costs can turn a property that looks profitable on paper into one that loses money every month. Two metrics do the real screening work before you buy.
Cap Rate: Screening a Deal
Cap rate is a property’s annual net operating income (NOI — rental income minus operating expenses, before mortgage payments) divided by its purchase price or current market value. It ignores financing entirely, which makes it useful for comparing similar properties in a market on an apples-to-apples basis. A good cap rate generally runs 5–10%: 4–6% is typical for stable, low-risk urban markets, 6–8% for mid-tier cities and suburbs, and 8–10%+ for higher-risk or up-and-coming areas where you’re being paid more for taking on more risk.
Cash-on-Cash Return: Evaluating Your Actual Deal
Cash-on-cash return measures your pre-tax cash flow against the actual cash you put in — down payment, closing costs, and any rehab spending — not the property’s full value. Calculate it by dividing annual pre-tax cash flow (NOI minus your annual debt service, i.e. mortgage payments) by your total cash invested. Because it accounts for financing, cash-on-cash return is the right metric for evaluating a specific financed deal rather than screening the market broadly. A good target is generally 8% or higher.
The Expense Assumptions That Make or Break the Math
Operating expenses typically consume 35–50% of gross rental income, with older properties trending toward the higher end — a mistake many first-time landlords make is assuming the mortgage payment is close to the full monthly cost. Vacancy needs its own line item even in strong markets: budget 5–10% of gross rent for vacancy in strong markets, 10–15% in average markets, and 15–20% in weaker markets or older properties needing more tenant turnover work.
Run Both Numbers Before You Offer
Cap rate tells you whether the property is priced reasonably for the market; cash-on-cash return tells you whether your specific financing turns that into real cash flow for you. A property can clear a healthy cap rate and still produce weak (or negative) cash-on-cash return if it’s financed with a small down payment and a high mortgage rate — which is exactly the scenario that turns into the rental income timing mismatch many new landlords get caught by after closing, not before.
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