The example property
Imagine a rental bought for 300,000. Rent is 2,000 a month, so full-year rent at 100 percent occupancy is 24,000. Assume 5 percent vacancy, which is 24,000 times 0.05, or 1,200. Collected rent is 24,000 minus 1,200, which is 22,800.
Operating expenses are 7,200 a year: property tax, insurance, repairs, maintenance and any management or utilities the owner pays. Loan payments are not an operating expense in these calculations. The loan is 210,000, with total annual principal and interest payments of 12,000. The owner put in 90,000 as a down payment plus 6,000 in closing costs, which makes 96,000 of cash invested. All figures are invented for illustration.
Cap rate: what the property earns before financing
Net operating income, or NOI, is collected rent minus operating expenses: 22,800 minus 7,200 equals 15,600. The cap rate is NOI divided by the purchase price: 15,600 divided by 300,000 equals 0.052, or 5.2 percent.
Cap rate ignores the loan, so it lets you compare two properties as if both were bought with cash. It does not tell you what you will actually take home.
Cash-on-cash return: what your own money earns
Pre-tax cash flow is NOI minus loan payments: 15,600 minus 12,000 equals 3,600. Cash-on-cash return is that cash flow divided by the cash you invested: 3,600 divided by 96,000 equals 0.0375, or 3.75 percent.
This number depends heavily on the loan terms and on how much you put down. It does not count principal you pay down, any rise in the property's value, or taxes.
Debt service coverage ratio: can the rent carry the loan
Divide NOI by the annual loan payments: 15,600 divided by 12,000 equals 1.3. The property earns 1.3 times what the loan costs. Lenders look at this ratio and set their own minimums, so ask yours what they require. A ratio below 1.0 means the property alone does not cover the loan payments.
Break-even occupancy: how empty can it get
Add operating expenses and loan payments, then divide by full-year rent: (7,200 plus 12,000) divided by 24,000 equals 19,200 divided by 24,000, or 0.80, so 80 percent. At that occupancy the property covers its costs and nothing more. Our assumed 95 percent occupancy leaves a 15-point cushion.
Stress the estimates before you trust the answers
Every input is a guess about next year. Test them. If vacancy doubles to 10 percent, collected rent falls to 21,600, NOI to 14,400, the cap rate to 4.8 percent, cash flow to 2,400, cash-on-cash to 2.5 percent and the coverage ratio to 1.2. If instead expenses rise by 2,000 to 9,200 at 5 percent vacancy, NOI is 13,600, the cap rate is about 4.5 percent, cash flow is 1,600, cash-on-cash is about 1.7 percent, coverage is about 1.13 and break-even occupancy is about 88 percent.
Notice that small changes in repairs or vacancy move returns a lot, because the margins are thin. Use actual bookkeeping, with income and expenses recorded by property, to replace guesses with real history. These numbers are screening tools, not tax or investment advice; talk to a CPA or financial professional about your own situation.
Common questions
Which of the four numbers matters most?
None alone. Cap rate compares properties, cash-on-cash shows return on your cash, coverage shows loan safety, and break-even shows how much vacancy you can survive. Look at them together.
Should I include a repair allowance even if nothing broke last year?
Yes. A year without major repairs is not a forecast. Many owners set aside a planned amount every year, based on the age and condition of the property.
Where does the data come from?
From your rent roll, loan statement, insurance and tax bills, and your bookkeeping. Clean records by property make these numbers far more reliable.
This guide is general information, not tax, legal or accounting advice. Rules, fees and due dates change; check with the IRS, the NJ Division of Taxation or a licensed professional for your situation.