Rental property cash flow: NOI, cap rate, cash-on-cash and DSCR

A rental’s cash flow is a year’s rent minus three things, taken in order: rent you won’t collect (vacancy), the cost of running the property (operating expenses) and the loan payments (debt service). The figure after operating expenses, net operating income (NOI), describes the property. The figure after debt service, cash flow, describes your deal. Cap rate, cash-on-cash return and debt-service coverage ratio (DSCR) are different ratios of those same lines, so one property can look fine on one and marginal on another.

How do you get from rent to cash flow?

Work down an operating statement one line at a time:

1. Gross scheduled rent: every unit rented all year at its lease or market rent, plus other income such as laundry or parking.
2. Minus vacancy and credit loss, which gives effective gross income (EGI): the rent you expect to collect.
3. Minus operating expenses, which gives net operating income (NOI).
4. Minus debt service (a year of principal and interest payments), which gives cash flow before tax.

The split matters because NOI doesn’t depend on how the property is paid for. Two buyers of the same building, one paying cash and one borrowing 80%, have the same NOI and very different cash flow.

What counts as an operating expense, and what doesn’t?

Operating expenses are the costs of running and maintaining the property. The Office of the Comptroller of the Currency (OCC), in its handbook for bank examiners, leaves out interest, principal, income taxes, depreciation and the capital items themselves. It does include a reserve for replacing capital items, counted whether or not the owner actually sets the money aside.

Two lines are easy to leave out, and leaving them out flatters the result:

• The replacement reserve. A roof or furnace doesn’t show up in a typical month’s bills, so a budget built from last year’s receipts can miss it. A monthly reserve spreads the cost over the years it lasts.
• Management. If you manage the property yourself, dropping the fee raises cash flow, but part of that cash flow is then pay for your time. A lender’s NOI analysis may count management fees and capital reserves even when they aren’t an actual or immediate cash expense.

Worked example: a $300,000 duplex, line by line

All of these figures are example assumptions, not market data. A duplex costs $300,000, plus $6,000 of closing costs and $4,000 of make-ready repairs. The buyer puts 25% down and takes a 30-year fixed loan at 6.75%. Each unit rents for $1,400 a month. Vacancy is 5%. Maintenance and management are each budgeted at 8% of rent collected (EGI).

The loan is $225,000, and its principal-and-interest payment is $1,459.35 a month. The cash invested is the down payment plus closing costs plus repairs: $75,000 + $6,000 + $4,000 = $85,000.

Cap rate vs. cash-on-cash return: which one should you use?

Use cap rate to compare properties and cash-on-cash return to judge a financing plan. Cap rate is the property’s income yield on its price, and it’s the same for every buyer. Cash-on-cash is what your own cash earns after debt service, so it changes with the down payment, the rate and the term.

The duplex shows how far apart they can land. Each borrowed dollar costs 7.78% a year in payments ($17,512.20 ÷ $225,000), while each dollar of price earns 6.00% in NOI. When the loan costs more per dollar than the property yields, borrowing lowers your return on cash instead of raising it. Bought for cash, the same duplex returns $17,992.80 ÷ $310,000 = 5.80% cash-on-cash. With the 75% loan it returns 0.57%. Part of that 7.78% is principal, which comes back to you as equity, so this comparison is about cash in hand, not total return.

Is there a “good” cap rate or cash-on-cash return?

No single number works everywhere. Cap rates are only comparable when NOI is built the same way, with the same vacancy, reserve and management assumptions. They also shift over time: changing interest rates can change cap rates, and with them property values. Two more useful checks: is the cap rate above or below what the loan costs per dollar borrowed, and does cash-on-cash beat what the same cash could earn elsewhere at similar risk?

What is DSCR, and why do lenders use it?

DSCR is NOI divided by annual debt service. At 1.00, NOI exactly covers the loan payments. Below 1.00, the owner makes up the shortfall from other money. The OCC calls it a measure of the borrower’s ability to service the debt. It also says the right level depends on the amortization period and how volatile the cash flow is. Lenders set their own minimums, so there is no single target.

The duplex’s DSCR of 1.03 means NOI covers the payments with about 2.7% to spare, or $480.60 a year. Suppose a lender wanted 1.20 (an example target, not a rule). The most debt service this NOI supports is $17,992.80 ÷ 1.20 = $14,994.00 a year, or $1,249.50 a month. At 6.75% over 30 years, that payment carries a loan of about $192,646. On a $300,000 price, the down payment rises from $75,000 (25%) to about $107,354 (35.8%).

Lenders don’t all measure coverage the same way. The OCC notes that a DSCR written into loan covenants can be defined differently from the one used to underwrite the loan. Some mortgage lenders’ investor “DSCR loans” use a simpler ratio: gross monthly rent divided by PITIA (principal and interest, taxes, insurance and any association dues). For this duplex that’s $2,800 ÷ $1,909.35 = 1.47, against 1.03 on NOI, so ask which formula a quote uses.

Conventional mortgage underwriting uses yet another screen. When a buyer counts a purchased rental’s income to qualify, Fannie Mae’s Selling Guide has the lender take 75% of gross monthly rent and subtract the property’s PITIA. For this duplex that’s $2,100.00 − $1,909.35 = $190.65 a month, well above the $40.05 from the full budget. The 25% haircut takes $700 a month off the rent, while this budget’s vacancy, maintenance, management, utilities and reserve come to $850.60.

How sensitive is cash flow to vacancy, repairs and rent?

Very sensitive when DSCR is this close to 1.00. Each row changes one example assumption:

Cash flow reaches zero at a vacancy rate of 6.70%, a break-even occupancy of 93.30%. That’s about 24 days empty per unit per year, so one slow turnover per unit uses up the margin. To find it, solve for the vacancy rate $v$ at which rent collected, less the 16% for maintenance and management, just covers the fixed costs ($8,820) plus debt service ($17,512.20): $33,600 × (1 − $v$) × 0.84 = $26,332.20.

Where the assumptions come from matters more than the formula:

• Vacancy. A vacancy factor is an estimate of vacancy over the property’s life, chosen with comparable properties in the same market in mind, so it can sit above or below today’s vacancy. The Census Bureau publishes rental vacancy rates by state and for the 75 largest metro areas. For a two-unit building, its own turnover history and local listings tell you more than a metro average.
• Maintenance and reserves. Replacement reserves vary with a property’s age and condition, and a flat percentage of rent ignores both. Pricing the roof, furnace, water heater and appliances by remaining life and replacement cost gives you a reserve you can check.

Do the 1% and 50% rules work?

They’re quick screens for deciding which listings deserve a full budget. On this duplex both are more pessimistic than the full budget:

• 1% rule (monthly rent should be at least 1% of the price): $2,800 ÷ $300,000 = 0.93%. It fails, yet the full budget shows positive cash flow.
• 50% rule (vacancy and operating costs take about half of gross rent): it estimates NOI at $16,800 and cash flow at −$712.20 a year. The itemized budget puts vacancy plus operating costs at 46.45% of gross rent and cash flow at +$480.60.

Neither rule knows the tax rate, the insurance quote, who pays utilities or how old the roof is. Use them to sort listings, then replace them with line items.

What does cash flow leave out?

Cash flow before tax is a one-year cash measure. Several things that decide whether a rental pays off sit outside it:

Early in a fixed-rate loan, most of each payment is interest. In year one the duplex’s payments are $15,114.22 of interest and $2,397.98 of principal. Cash flow plus principal paydown is $2,878.58, or 3.39% of the $85,000 invested. The example 3% appreciation would add $9,000, more than three times as much. So most of the projected return rests on an assumption about prices, not on the rent.

The tax return tells a different story. Under IRS Publication 527, a residential rental building is depreciated over 27.5 years, with a mid-month convention in the first year; the land is not depreciated. Repairs are deductible, but improvements such as a new roof are capitalized and depreciated. Year one’s $15,114.22 of interest plus a full year’s $8,727.27 of depreciation comes to $23,841.49. That’s more than the $20,092.80 the duplex earns before them: NOI with the $2,100 reserve added back, because money set aside hasn’t been spent. So the rental could report a tax loss while putting cash in your pocket. Whether you can use that loss depends on the passive activity rules in the same publication.

A one-year snapshot also leaves out rent growth, rising costs and the eventual sale. To see those, lay out each year’s cash flow and a sale price and compute the internal rate of return.

Try it

• Rental property calculator: purchase price $300,000, closing costs $6,000, repairs before renting $4,000, down payment 25%, interest rate 6.75%, loan term 30 years, monthly rent $2,800, other income $0, vacancy 5%, property tax $3,600 a year, insurance $1,800 a year, maintenance 8% and management 8% of rent collected, HOA dues $0, utilities you pay $110 a month, capital-expenditure reserve $175 a month. Expect effective gross income $31,920.00, operating expenses $13,927.20, NOI $17,992.80, cap rate 6.00%, cash flow $40.05 a month ($480.60 a year), cash-on-cash 0.57%, DSCR 1.03 and break-even occupancy 93.30%. Then set vacancy to 8% to watch the cash flow turn negative: −$30.51 a month, with DSCR 0.98.
• Mortgage calculator: home price $300,000, down payment 25%, loan term 30 years, interest rate 6.75%, property tax per year $3,600, insurance per year $1,800, HOA dues $0 and PMI set to None. Principal and interest come to $1,459.35, and $1,909.35 with tax and insurance.
• DSCR calculator: choose Property income (NOI) as the cash flow measure, then enter an annual cash flow of $17,992.80, no existing debt payments, a $225,000 loan amount, an annual interest rate of 6.75%, a 30-year amortization period and monthly payments (12 a year). Expect DSCR 1.03. With a target DSCR of 1.20, the maximum loan is $192,646.26; choose Maximum loan under Find to see how it is worked out.
• NPV and IRR calculator: for a multi-year view, enter the cash invested as a negative first cash flow, then each year’s cash flow, adding the sale proceeds (after selling costs and the loan payoff) to the last year.

These are educational estimates, not investment, tax or lending advice.