Cap Rate With a Mortgage: Positive Leverage and What Debt Doesn't Change

Cap rate does not include your mortgage. It is built from net operating income, and NOI stops before debt service, so the cap rate on a property is the same whether you pay cash or borrow 80% of the price. Does cap rate include debt service? No. Does the cap rate change with your loan amount or your interest rate? Also no. What a loan changes is the return on the cash you put in, and whether the property carries itself.

So the useful question is not what a cap rate with a mortgage looks like. It is how the cap rate compares to the yearly cost of the loan. Higher cap rate than loan cost, and borrowing lifts your return. Lower, and borrowing drags it down. That comparison is the other half of the story in how cap rates and interest rates move together.

Does cap rate include mortgage payments?

No. NOI counts what the property collects and what it costs to operate: vacancy loss, property taxes, insurance, maintenance, reserves and management. It leaves out principal and interest, income taxes, depreciation and capital projects. Two buyers looking at the same house, one paying cash and one borrowing 90%, calculate the same cap rate.

That is deliberate. Cap rate measures the property; financing measures you. A cap rate that shifted with each buyer’s loan could not be used to compare two buildings.

What happens if you subtract the loan anyway

You get cash flow, not NOI. Divide that by the price and the answer is not a cap rate and will not compare to anything. Keep debt service out of NOI and bring it in as a separate step.

The test that matters: cap rate against the loan constant

A loan’s annual cost is not its interest rate. It is the mortgage constant: twelve payments of principal and interest divided by the original balance. On a 30-year loan at 7.25% the constant is about 8.2%. Shorter terms raise it, longer terms lower it, and the annual loan cost by rate and term is worth keeping handy.

Then compare the two numbers:

• Cap rate above the constant is positive leverage. Each borrowed dollar earns more than it costs, so cash on cash return lands above the cap rate.
• Cap rate below the constant is negative leverage. Each borrowed dollar costs more than it earns, so cash on cash return lands below the cap rate, and a big enough loan pushes it under zero.

The standard example with 20% down

Take the example house. It costs $500,000 and rents for $4,000 a month. Allow 5% vacancy, $6,000 of property taxes, $2,500 of insurance and 18% of collected income for maintenance, reserves and management. NOI is $28,892 and the cap rate is 5.78%.

Now finance it. Put 20% down: $100,000 of cash and a $400,000 loan on 30 years at 7.25%. The payment is about $2,728 a month, or $32,736 a year. NOI of $28,892 minus $32,736 leaves negative $3,844. Cash on cash return is about negative 3.8% before closing costs.

Nothing moved the cap rate. It is still 5.78%, the same number a cash buyer would get. The loan turned a 5.78% yield into a yearly hole, because 8.2% costs more than 5.78% earns.

A bigger down payment shrinks the hole without closing it

Put 40% down instead: $200,000 of cash and a $300,000 loan at the same rate. Debt service is $24,552, cash flow is $4,340, and cash on cash return is about 2.2%. Positive, and still well under the 5.78% cap rate. While the constant sits above the cap rate, every borrowed dollar pulls the return down, so no down payment gets you above 5.78%. All cash is the ceiling here, which is where cap rate and cash on cash return part ways.

What positive leverage looks like

Keep the same income and buy it cheaper, the way that rent roll might price in a lower-cost market. At $325,000, NOI of $28,892 is an 8.89% cap rate. Put 20% down: $65,000 of cash and a $260,000 loan at 7.25%, or $21,278 a year. Cash flow is $7,614 and cash on cash return is about 11.7%. The cap rate cleared the constant, so the debt raised the return above the all-cash 8.89%.

Cap rate vs debt yield

Debt yield is NOI divided by the loan amount, not the price. Lenders use it because it ignores the rate, the term and the appraisal. A $400,000 loan against $28,892 of NOI is a 7.2% debt yield. At $300,000 it is 9.6%. Many lenders want 10% or more, though the floor varies by lender and property type.

The two are the same number scaled by loan size: debt yield equals the cap rate divided by the loan-to-value ratio. A 5.78% cap rate at 80% is a 7.2% debt yield; at 60% it is 9.6%. So a lender’s debt yield floor is really a limit on how much it will lend against a given cap rate.

Coverage and break-even

The debt service coverage ratio is NOI over debt service. At $400,000 borrowed it is 0.88, and lenders commonly want 1.20 to 1.25, so that loan would not be written against this income. At $300,000 it is 1.18, still short. The break-even point says the same thing from the rent side: with the $400,000 loan the house needs more than 100% occupancy to cover its costs, while the $300,000 loan breaks even near 84%.

What debt does not change

Debt does not change NOI, the cap rate, what the property is worth to the next buyer, or the exit cap rate. The simple version makes it plain: $30,000 of NOI on a $500,000 price is a 6% cap rate with any loan or none. What debt changes is your cash return, your risk if rents stall, and how much of the sale price comes back to you.

Run your own numbers

The Cap Rate Calculator on the home page turns rent, vacancy and expenses into NOI and a cap rate. Get that number first, set it against your loan constant, and you will know before you offer whether the debt helps or hurts.