Cash on Cash Return

Cash on cash return is annual pre-tax cash flow after the mortgage divided by the cash invested: down payment, closing costs and repairs. It is the leveraged counterpart of cap rate. Buy a property for cash and the two are nearly equal; add a loan and they diverge.

The direction of the gap depends on the loan's annual cost. A 30-year loan at 7.25% costs about 8.2% of the balance each year in payments. If the cap rate is above that, borrowing lifts cash on cash above the cap rate. If it is below, borrowing drags it down, and more leverage makes it worse.

On a $500,000 property with $30,000 of NOI, cap rate is 6%. All cash, the return is about 5.8%. With 25% down at 7.25%, cash flow is slightly negative and cash on cash is below zero. At 5% the same loan produces a 4.2% cash on cash return. Cap rate measures the property; cash on cash measures your deal.

Further reading: Cash on Cash Return on Wikipedia.