Rental Property Basics: Cash Flow and Cap Rate Explained
- Isaac Robles
- Aug 29
- 6 min read
Whether you’re buying your first rental or sharpening your analysis, it pays to understand why these numbers matter. A deep grasp of cash flow and cap rate is valuable because they are the two most common ways investors judge a property’s strength.
Without these measurements, you’re guessing instead of measuring.
Cash flow tells you if the property pays you every month.
Cap rate helps you compare properties without taking into account different financing terms. Cap rate strips those away so you can judge the property itself, not your loan setup.
Together, they help you avoid costly mistakes and spot better deals. This guide keeps the math simple for beginners while adding enough depth for experienced investors.
Plain‑English Definitions |
Cash Flow: The money left over each month after rent comes in and all bills are paid (mortgage, taxes, insurance, repairs, utilities you cover, management, etc.). It's what’s actually going into your pocket at the end of the month. |
Cap Rate (Capitalization Rate): A snapshot return that looks at the property as if you bought it in cash. Think of it as the property’s “report card”. It shows how efficiently it produces income compared to its price Formula: Cap Rate = NOI ÷ Purchase Price. |
NOI (Net Operating Income): Yearly income the property produces before the mortgage. It’s like looking at a paycheck before you pay your car loan. It shows the property’s earnings before debt. Formula: NOI = Effective Rent – Operating Expenses. |
Understanding NOI is the bridge to the next step: breaking down a property’s full income and expense picture so you can see where that number comes from.
Step 1: Build the Income and Expense Picture
Income
All three of these points work together to show your true rental income.
Gross Scheduled Rent: What you’d collect if every unit is occupied all year.
Vacancy/Collection Loss: A safety allowance (often 3–8% depending on area). Think of it as “rainy day rent”—not every month will be perfect.
Effective Gross Income (EGI): Rent after vacancy. EGI = Gross Rent × (1 – vacancy%).
Gross rent is the starting point, vacancy reminds you that some months won’t be perfect, and EGI is the realistic number you can actually count on. In the big picture, this gives you a solid foundation before you subtract expenses to see how profitable the property really is.
Let’s move on to expenses, the other side of the equation.
Operating Expenses (no mortgage yet)
Make sure to include: Property taxes, insurance, repairs/maintenance, management fees, utilities you pay (water/sewer, trash, common electric, heat if applicable), HOA, lawn/snow, pest, admin.
CapEx (Capital Expenditures): Big‑ticket, non‑annual items (roof, boiler, windows). Many investors set aside 3–8% of rent for CapEx reserves. Think of CapEx like a savings jar for major home repairs.
Taken together, these expenses show the real costs of keeping a property running day to day AND year to year. They remind you that rent isn’t pure profit. There are ongoing costs you must plan for.
Net Operating Income (NOI)
NOI = EGI – Operating Expenses
NOI is the bridge between income and expenses. It tells you what the property truly earns before the loan, combining everything you’ve just calculated into one number. In simple terms, it’s the property’s “report card” for profitability before debt. This figure sets the stage for evaluating cap rate and cash flow.
Step 2: Find Cap Rate
Cap rate is meant to show the property’s return without considering your loan. This makes it simple to compare one property to another, because different loans can make the same property look very different on paper. By keeping it loan‑free, cap rate focuses only on the property itself. Two identical buildings have the same cap rate regardless of your loan.
It’s called “capitalization rate” because it shows how quickly the property’s income could pay back its purchase price. It's like asking, ‘If I bought this in cash, how long would it take the rent to cover what I paid?’
Cap Rate = NOI ÷ Purchase Price
Caution:
Higher cap is not always “better.” Sometimes it signals higher risk, bigger repairs, or tougher operations. Imagine a used car with great gas mileage but constant breakdowns.
Cap rate isn’t a magic number. It shows you how efficient a property is at making money compared to its price. In the bigger picture, cap rate helps you line up different properties side by side and judge their earning power before worrying about loans or financing.
Now, let’s bring in financing and see how it changes the picture with cash flow.
Step 3: Layer in Financing to See Cash Flow
After NOI, take away the annual loan payment (the principal + interest) to see your annual cash flow (the money left after the bank is paid).
Cash Flow (before taxes) = NOI – Annual Loan Payment
To judge your cash invested, look at cash‑on‑cash return:
CoC = Annual Cash Flow ÷ Total Cash In (down payment + closing costs + initial repairs)
Cash-on-cash return is just a way of asking: “For every dollar I put in, how many cents do I get back each year?”. It compares the money you earn from the property each year to the actual cash you invested (down payment + closing costs + repairs). It's like filling your car with gas. Cash-on-cash tells you how far your money is taking you compared to what you put in the tank.
All of this shows how the loan changes the picture.
NOI is what the property makes before the bank gets paid. Once you add the loan, you see what’s left for you each month. Simply put, this is the point where the math turns into real money in your pocket. It’s the test of whether the deal really fits your budget and goals.
A Duplex Example (Simple + Realistic)Numbers are illustrative—use your actual quotes for taxes, insurance, and utilities. Purchase: $250,000 duplex Income: Rents: $1,350 per unit → $2,700/mo → $32,400/yr Vacancy (5%): $1,620 → EGI (Rent After Vacancy/Non-Payment): $30,780 Expenses:
Cap rate (with management): 15,455 ÷ 250,000 = 6.18% Financing: 20% down, 30‑yr loan on $200,000. Approx. P&I: $1,297/mo → $15,566 a year Cash flow (with management): 15,455 – 15,566 = –$111/yr (roughly break‑even)Cash flow (self‑managing): remove the 8% management line → $2,351/yr (~$196/mo)
With management included, the property basically breaks even because the NOI and loan payment are about the same. Without paying a manager (self-managing), that cost goes away, so the cash flow turns positive.
Total cash in: $50,000 down + ~$7,500 closing + ~$8,000 initial repairs = $65,500 Cash‑on‑cash (self‑managing): 2,351 ÷ 65,500 = 3.6% What this shows
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Quick 5‑Minute “Back‑of‑the‑Envelope” Test
Multiply monthly rent by 12.
Subtract vacancy (start with 5%).
Subtract operating expenses. A rough starter estimate is 45–55% of rent in older Midwest housing (before mortgage).
The result is NOI. Divide by price for the cap rate.
Subtract your annual mortgage to eyeball cash flow. This is only an estimate.
Common Pitfalls (and Fixes)
Using pro‑forma rents: “Pro‑forma” just means projected or hoped‑for rents, not what tenants are actually paying today. Always verify with real comps, not just the assumptions.
Underestimating expenses: Don’t forget water/sewer, lawn/snow, pest, turnovers, leasing fees.
Ignoring CapEx: Old roofs and boilers can wipe out a year’s profit... budget for reserves.
Confusing NOI with profit after mortgage: NOI is before debt.
Sometimes high capital = high headache. Weigh risk, location, and long‑term demand.
Cash Flow and Cap Rate Explained: In Summary
Cap rate measures the property’s earning power before debt, while cash flow shows what you keep after paying the bank. Together they give you the full picture (cap rate for comparing properties fairly, and cash flow for seeing if the deal works for your wallet).
For newer investors, this is the foundation of good decisions; for experienced ones, it’s a reminder to double‑check with real numbers, stress‑test your assumptions, and plan for big repairs (CapEx). I hope you feel like cash flow and cap rate were properly explained!
As Milwaukee’s housing expert, I can run rent comps, taxes, and a full underwriting worksheet on any property you’re considering; then come up with strategies (self‑manage vs. pro management, rehab scope, financing) for your goals.
When you’re ready, let’s walk a deal together and make the math work for you.
Educational only: talk to a licensed lender, CPA, and attorney for financing, tax, and legal advice specific to your situation.
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