Cap Rate, Cash-on-Cash, and DSCR: What Each One Actually Measures

Three numbers get quoted about every rental property, and most people treat them as three ways of saying the same thing. They are not. They answer three genuinely different questions, they use different inputs, and a property can look strong on one while failing badly on another.

Here is the version of that which costs people money. A $265,000 rental collecting $2,200 a month produces a 4.42% cap rate — modest, defensible, the kind of number you would keep looking at. Finance it the ordinary way, with 25% down, and the same property produces −5.78% cash-on-cash and a DSCR of 0.73. It loses $362 a month and does not generate enough income to cover its own mortgage.

Nothing about the building changed between those two paragraphs. What changed is which question was being asked.

A note before you start. This is general education, not investment advice, and nothing here is a recommendation about any property. The worked example uses illustrative inputs stated on the page — a $265,000 purchase, $2,200 monthly rent, 25% down at 7.125% over 30 years — and every figure derived from them is arithmetic you can follow and check. Real property taxes, insurance, and rents vary enormously by state and by property; this site's per-state calculators use sourced figures for the first two, and rent is always something you have to establish yourself, because no honest national rent dataset exists at the property level.

1. The three questions

Before the formulas, the questions. This is the part that makes the rest stick.

Cap rate is a property metric. Cash-on-cash is a deal metric. DSCR is a lending metric. Using one to answer another's question is the single most common error in rental analysis.

2. Building up to NOI

Everything starts with net operating income, and NOI is built in a specific order for a specific reason.

Gross scheduled rent — what the property would collect fully occupied at market rent. $2,200 × 12 = $26,400.

Less vacancy. No property is occupied every day of every year. Turnover takes weeks; the occasional bad month takes longer. At 8%: −$2,112.

Effective gross income — what you actually collect. $24,288. This is the number that matters, and it is the base for the management fee.

Less operating expenses. Everything required to run the property:

Net operating income = $24,288 − $12,568 = $11,720.

Two things about that list are deliberate and worth defending.

Management is charged on effective gross income, not scheduled rent. A management company bills a percentage of what it collects. If the unit sits empty for a month there is no rent and no fee. Charging the fee against scheduled rent would invent an expense in exactly the months you already lost the income — paying twice for the same vacancy.

The capital reserve is an operating expense even though you did not spend it this year. A roof with fifteen years left is not free; it is a cost you are spreading across the years before you replace it. Leaving it out does not make the roof cheaper — it makes this year's NOI wrong and next decade's cheque a surprise.

3. Cap rate: the property, without you in it

Cap rate = NOI ÷ purchase price (or current value)

$11,720 ÷ $265,000 = 4.42%

The defining feature of cap rate is what it excludes: the mortgage. That exclusion is not an oversight, it is the entire point.

Two people buy the same house on the same day. One pays cash. One puts 20% down at 7%. If debt service were inside NOI, that single building would appear to be two different investments depending on which of them was standing there — and comparing it to the property down the street would become impossible. Keeping financing out is what makes cap rate a statement about the asset rather than about the buyer.

That also tells you exactly what cap rate is for and what it is not for:

Use it to compare properties against each other, compare a property against its local market, and value a property from its income (NOI ÷ target cap rate = price).

Do not use it to decide whether you can afford the deal, or whether it produces cash. It cannot answer either, because it does not know how you are paying.

4. Cash-on-cash: your money, your deal

Now finance it. 25% down on $265,000 is $66,250; the loan is $198,750 at 7.125% over 30 years.

Monthly principal and interest: $1,339.02. Annual debt service: $16,068.

Annual cash flow = NOI − debt service = $11,720 − $16,068 = −$4,348, or −$362 a month.

Cash-on-cash = annual cash flow ÷ cash invested

Cash invested is not the down payment alone — it is every dollar out of pocket. Down payment $66,250, plus roughly $9,000 of closing costs and initial work, gives $75,250.

−$4,348 ÷ $75,250 = −5.78%

The same property that produced a respectable-looking 4.42% cap rate loses money every month once financed at ordinary terms. Neither number is wrong. Cap rate said the asset yields 4.42%; borrowing at 7.125% against an asset yielding 4.42% is negative leverage, and cash-on-cash is where that shows up.

Negative leverage is the concept worth taking away. When your borrowing rate exceeds the property's unlevered yield, every additional dollar of debt makes your cash return worse rather than better. In a low-rate environment leverage amplifies returns; when rates exceed cap rates, it amplifies losses.

5. DSCR: what the lender is looking at

DSCR = NOI ÷ annual debt service

$11,720 ÷ $16,068 = 0.73

A ratio of 1.0 means the property exactly covers its debt. Below 1.0 it does not, and the shortfall comes from you.

Most lenders writing investor loans want 1.20 or better — a 20% cushion for the months when something breaks or the unit sits empty. At 0.73, this property is not close.

The trap: the lender's DSCR is not your DSCR

This matters enormously and it catches experienced people.

Many DSCR lenders compute the ratio as gross rent ÷ PITIA — principal, interest, taxes, insurance, and association dues. Note what is missing: vacancy, management, maintenance, and capital reserves.

Run our property that way. Monthly PITIA is $1,339.02 of principal and interest, plus $331.25 of tax and $154.17 of insurance, giving $1,824.44. Gross rent is $2,200.

$2,200 ÷ $1,824.44 = 1.21

The lender sees 1.21 and approves. You see 0.73 and lose $362 a month. Both calculations are correct. They are answering different questions — the lender wants to know whether the rent covers the payment, and you want to know whether you make money — and the gap between them is entirely the expenses the lender's formula omits.

A loan approval is not a verdict on the deal. It is a verdict on the loan.

6. What leverage does to all three at once

Cap rate does not move when you change the down payment — the property yields what it yields. The other two move a great deal, and watching them move is the clearest demonstration of what negative leverage actually is.

Same property, same $11,720 of NOI, same 7.125% rate. Only the down payment changes.

Cap rate stays at 4.42% down every row of that table. It is a property fact.

Three things fall out of it.

More leverage makes this deal worse, not better. That is negative leverage stated as a table: borrowing at 7.125% against an asset yielding 4.42% means every additional dollar of debt subtracts from your return. In a lower-rate environment the column would run the other way, and the same table is how you would see that.

Cash flow does not turn positive until roughly 45% down. Solving directly: debt service equals NOI at a loan of about $144,967, which is 54.7% loan-to-value — a 45.3% down payment. To reach a lender's typical 1.20 DSCR you would need to put 54.4% down. Neither is a normal investment purchase.

The all-cash row is the honest benchmark. Paying cash produces $11,720 a year on $274,000 invested — a 4.28% return, and note that it is slightly below the 4.42% cap rate because cash invested includes the closing costs the purchase price does not. That is the number to compare against whatever else the money could do, and it is what leverage is supposed to improve on. Here it does not.

The general rule this table illustrates: leverage amplifies the gap between your borrowing rate and the property's yield, in whichever direction that gap runs. Nothing about the building determines the sign. The rate does.

7. The sanity check that catches most bad pro-formas

Before you look at any of the three metrics, look at the expense ratio:

Operating expenses ÷ effective gross income

On our property: $12,568 ÷ $24,288 = 51.7%.

A ratio in the 35% to 55% band is normal for a single-family rental with third-party management. Well under 35% almost always means something is missing, and everything downstream inherits the error, because NOI is the input to all three metrics.

Here is the same property as a seller might present it. Drop vacancy, drop management, drop the capital reserve, and use the seller's own long-frozen property tax bill of $2,100 rather than what it will be reassessed at:

A 3.14-percentage-point swing in cap rate and an $8,330 swing in NOI, with no dispute about a single physical fact. Every change is a line the pro-forma either omitted or priced at the seller's cost rather than yours.

The 24.1% expense ratio is the tell. You do not need to audit line by line to know that number is wrong — you need to notice it and then find out why.

8. What all three miss

An honest article about these metrics has to say what they do not capture, because a property that fails all three can still be a defensible hold.

Principal paydown. Every payment retires loan principal, and that is real equity arriving monthly. On our property, the first year retires roughly $2,000 and it accelerates — a 30-year loan pays back around three times as much principal in year ten as in year one. None of the three metrics counts it.

Appreciation. Historically the largest component of return on a leveraged property, and entirely absent from all three. It is also the least certain, which is why it should be treated as a scenario rather than an assumption.

Tax effects. Depreciation can turn a cash-positive property into a paper loss, and the passive-loss rules decide whether you can use it. Recapture takes some of it back at sale. None of that appears in cap rate, cash-on-cash, or DSCR.

Your own labour. Self-managing removes the management fee from the expense list and replaces it with your time. That improves every metric on the page and is not free.

So the honest hierarchy is: use these three to decide whether the deal works as an operating business, and then look at total return separately to decide whether it works as an investment. A property with −5.78% cash-on-cash is a real problem regardless — you fund $362 a month indefinitely — but a property at +2% cash-on-cash with meaningful paydown may be a considerably better long-term holding than one at +5% with none.

9. Reading the three together

One row deserves singling out. "Negative cash flow, strong paydown" is the only combination on that list where the metrics are all unfavourable and the deal may still be defensible — and it is also the combination people most often talk themselves into. The test is whether you can name the amount, in dollars per month, that you are choosing to fund, and for how many years, before you buy. If you can, it is a position. If you cannot, it is a hope.

The pattern worth internalising: when two metrics disagree, the disagreement is the information. A gap between cap rate and cash-on-cash is a statement about your financing. A gap between your DSCR and the lender's is a statement about which expenses got left out. Neither is noise.

Frequently asked questions

Why isn't my mortgage in the net operating income? Because NOI describes the property and a mortgage describes the buyer. If financing were inside it, the same house would look like two different investments depending on who bought it, and cap rate would stop being comparable between properties. Debt enters one line lower, where cash flow, cash-on-cash, and DSCR all use it.

What is a good cap rate? There is no universal answer, and anyone offering one is not accounting for market. Cap rates vary by metro, property class, and interest rate environment, and a 4% cap in one market can be more attractive than an 8% cap in another once risk and growth are considered. Compare against comparable properties in the same market, not against a national rule.

Why is my management fee calculated on collected rent rather than the lease amount? Because that is how a management company bills — a percentage of what they collect. If the unit is empty there is no rent and no fee. Charging it against scheduled rent would create an expense in exactly the months you already lost the income.

My lender says the DSCR is 1.21 and my own spreadsheet says 0.73. Who is wrong? Neither. Many DSCR lenders divide gross rent by PITIA and never subtract vacancy, management, maintenance, or reserves. The lender is measuring whether the rent covers the payment; you are measuring whether you make money. Both calculations are correct and only one is about your outcome.

Should I include a capital reserve if the roof is new? Yes. A new roof is not a free roof — it is a roof whose cost you are spreading over the years before you replace it. Omitting the reserve does not remove the future cost, it just moves it out of the analysis and into a surprise.

What expense ratio should I expect? Roughly 35% to 55% of effective gross income for a single-family rental with third-party management is ordinary. Below 30% is a prompt to check what is missing rather than a sign of a good deal.

Is negative cash flow always bad? Not automatically, but it should be a decision rather than a discovery. A property losing $362 a month costs $4,344 a year of your own money, indefinitely, and the case for it has to come from paydown and appreciation — neither of which is guaranteed. What is never defensible is finding out after closing.

Which of the three matters most? Cash-on-cash, if you have to pick one, because it is the only one that describes what happens to your money. But the expense ratio matters before any of them, since all three are built on NOI and a wrong NOI makes all three wrong together.

What to do next

Run your own numbers before you run anyone else's. The rental analysis calculator takes gross rent through vacancy to NOI, then produces cap rate, cash flow, cash-on-cash and DSCR — with management charged on collected rent, the mortgage kept out of NOI, and a sanity panel that flags the omissions that flatter a deal.

• Hold-period return calculator — what these three metrics leave out: paydown, appreciation, and the sale
• Investment cash-to-close — what getting in actually costs, including the reserves lenders require
• Rental property analysis by state — sourced tax and insurance figures for your state
• How our figures are sourced

This article is general education about rental property metrics, not investment, tax, or financial advice, and nothing here is a recommendation about any property or market. The worked example uses illustrative inputs stated on the page; every derived figure is arithmetic on those inputs, not a projection about any real property. Property tax, insurance, and rent vary substantially by state and by property. Consult qualified professionals about your own situation before buying.