Every rental property listing you look at will mention the cap rate. Every YouTube investing video will mention cash-on-cash return. And every investor who has been doing this for more than a few years will eventually bring up IRR. All three are legitimate measures. None of them answers the same question, and the biggest mistake beginner investors make is using the wrong one for the decision they are trying to make.
I have owned four rental doors for seven years, and I track all three numbers on every property. The spreadsheet has taught me that the cap rate is useful for exactly one thing, cash-on-cash is useful for a different thing, and IRR is the number that actually tells me whether a deal was worth doing in hindsight. Here is how each one works, with real numbers from deals that look like the ones you are probably evaluating.
Cap rate: the property’s earning power, ignoring your financing
Cap rate is net operating income divided by purchase price. That is it. No mortgage, no down payment, no leverage. Just how much the property earns relative to what it costs.
NOI is annual rent minus operating expenses (property taxes, insurance, maintenance, management, vacancy allowance). It does not include your mortgage payment, because cap rate is measuring the property’s economics, not yours.
A $200,000 property that generates $18,000 in annual rent and has $6,000 in operating expenses has an NOI of $12,000 and a cap rate of 6%.
Cap rate is useful for one thing: comparing two properties in the same market. If property A has a 6% cap rate and property B has a 7.5% cap rate, property B earns more per dollar of purchase price before financing. That comparison is clean because the financing is stripped out, and two investors looking at the same property will calculate the same cap rate regardless of how they plan to pay for it.
Cap rate is not useful for deciding whether a leveraged deal works for you, because it ignores the mortgage, which is the biggest line item in most investors’ monthly cash flow.
Cash-on-cash: your return on the cash you actually invested
Cash-on-cash return is annual pre-tax cash flow divided by total cash invested. This is the number that tells you what your money is doing.
Annual cash flow is NOI minus your annual mortgage payment (principal plus interest). Total cash invested is your down payment plus closing costs plus any rehab you funded out of pocket.
On the same $200,000 property with $12,000 NOI: if you put $50,000 down and your annual mortgage payment is $9,600, your cash flow is $2,400 per year, and your cash-on-cash return is 4.8%.
That 4.8% is not the same as the 6% cap rate, and the difference is the cost of leverage. Your mortgage is taking $9,600 of the $12,000 NOI, and what is left for you is $2,400. Whether 4.8% on your $50,000 is a good return depends on what else you could have done with $50,000. In a world where a savings account pays 4.5%, a 4.8% cash-on-cash return with the management burden of a rental property is a legitimate question.
Cash-on-cash is useful for deciding whether a specific deal with your specific financing puts enough cash in your pocket to justify the work. It is not useful for measuring the total return of the investment over time, because it ignores principal paydown and appreciation.
IRR: the whole picture over time
Internal rate of return is the annualized return on your investment that accounts for all cash flows over the entire holding period, including cash flow during ownership, principal paydown, appreciation, and the net proceeds when you sell. It is the closest thing to a single number that answers “was this deal worth doing.”
IRR is harder to calculate than cap rate or cash-on-cash because it requires assumptions about future appreciation, future rent growth, and the eventual sale price. I run it on each of my doors using the actual numbers I have accumulated so far, updated with an assumed exit price based on current comps.
On the $200,000 property, if I hold it for 10 years, collect the cash flow, let the tenant pay down the mortgage, and sell for $260,000 (3% annual appreciation), my IRR is roughly 12-14% depending on rent growth assumptions. That is meaningfully higher than the 4.8% cash-on-cash because it includes the equity I built through principal paydown and the appreciation I captured on the leveraged asset.
IRR is useful for evaluating a deal holistically. It is not useful for quick comparisons between listings, because every investor’s IRR on the same property will be different depending on their financing, their hold period, and their exit assumptions.
Which number for which decision
Here is the part I wish someone had written for me when I started.
Comparing two properties in the same market: use cap rate. It strips out financing and measures the property.
Deciding whether a specific deal cash-flows enough to justify the work: use cash-on-cash. It measures your actual money in your actual pocket.
Evaluating whether a deal was (or will be) worth doing overall: use IRR. It measures the whole investment over time.
What not to do: use cap rate to decide whether your leveraged deal works. The 8% cap rate on a listing does not mean you will earn 8%. It means the property earns 8% on its purchase price before your mortgage takes its share. After leverage, your cash-on-cash may be 3%, and after 10 years of holding, your IRR may be 14%. All three numbers can be true about the same deal at the same time.
The spreadsheet version
I track all three on each of my four doors. The cap rates range from 5.4% to 7.8%. The cash-on-cash returns range from 3.1% to 6.2%. The estimated IRRs, using actual cash flows and current comp-based exit prices, range from 9% to 16%. The door with the lowest cap rate has the highest IRR, because it appreciated more than the others. The door with the highest cash-on-cash has the lowest IRR, because the neighborhood has been flat on appreciation and the total return is mostly from cash flow.
None of those numbers is wrong. Each one is answering a different question. The investors who get into trouble are the ones who use only one number and think it is answering all three.
I wrote a more detailed article about the line items most rental calculators skip, which goes deeper into the cash-flow side of this. If you are evaluating your first deal, start there and come back to this one when you are ready to compare.