Cap Rate, Cash-on-Cash, and the Numbers That Predict a Rental

A rental is not a home. It is a small business you are pricing, and the listing photos are irrelevant to whether it makes money. The math does not care about the backsplash.

Here are the three numbers that actually predict whether a rental works — and the trap hiding inside each one.

Cap rate: the honesty check

Cap rate = net operating income / purchase price. NOI is rent after every operating expense — taxes, insurance, maintenance, vacancy, management — but before the mortgage.

The trap: sellers quote NOI with the expenses conveniently missing. A "7% cap" that assumes zero vacancy, no maintenance, and no management is a fantasy number. Rebuild NOI yourself:

• Vacancy: budget 5-8%, not zero.
• Maintenance and capex: 1% of value per year is a floor, not a ceiling.
• Management: 8-10% of rent even if you self-manage — your time is not free.

A cap rate is only as honest as the expense line you refuse to skip.

Cash-on-cash: what you actually earn

Cap rate ignores your loan. Cash-on-cash = annual pre-tax cash flow / total cash invested (down payment, closing costs, and rehab). This is the number that answers "what is my money actually doing."

A property can have a healthy cap rate and a miserable cash-on-cash if the financing is expensive. In a high-rate market, plenty of "good deals" produce negative cash flow the day you close — you are paying to own them.

The 1% rule (and why it is a smoke detector, not a rule)

Monthly rent divided by purchase price. Above ~1% and the deal is worth a real underwrite; well below and it usually only pencils on appreciation you are hoping for. It is a five-second filter to kill obvious losers — not a substitute for the two numbers above.

The expenses that ambush new investors

• Property taxes reassess on sale — the seller's tax bill is not your tax bill.
• Insurance in climate-exposed markets can double the pro forma.
• Turnover costs more than vacancy: make-ready, leasing fees, and a month of no rent per turn.
• The big-ticket clock: roof, HVAC, and water heater all have expiration dates. If they are old, that is deferred cash flow, not a bonus.

Underwrite before you fall in love

Run the numbers before you tour, not after you have decided you want it — motivated reasoning is how bad deals get bought. Paste the listing into What's Wrong With This Property? to surface the risk factors the pro forma leaves out: the roof at year 24, the flood zone that spikes insurance, the "quiet street" that is actually a rental-killing cut-through.

The property does not have to be beautiful. It has to clear the math. Make it prove it.