Cap rate is not your return.
What cash-on-cash and the dollar walk show that a cap rate quietly hides.
The seller's number
Cap rate is the headline on almost every listing, and it is the seller number, not yours. It is net operating income divided by price, with no loan in the math. It assumes you pay all cash. Almost no one buying net lease pays all cash. So the cap rate tells you how the building is priced. It does not tell you what you take home.
What you actually pocket
The number that answers your question is cash-on-cash. Take the net operating income, subtract a full year of loan payments, and divide what is left by the cash you put in. That is the return on your own money in year one, after the bank has been paid. It is the first honest figure in the stack.
- Price
- $4,000,000
- Going-in cap rate
- 7.0%
- Net operating income
- $280,000
- Loan at 60% of value
- $2,400,000
- Equity in
- $1,600,000
- Interest-only at 6.5%
- debt service $156,000, cash flow $124,000, 7.75% cash-on-cash
- Amortizing 30-year at 6.5%
- debt service about $182,000, cash flow about $98,000, about 6.1% cash-on-cash
Illustration. Same price, same rent, same rate. The loan structure alone moves the return by more than a point and a half.
Read that twice. Nothing changed about the building. Same price, same tenant, same interest rate. The only difference is whether the loan pays down principal or not, and the return swung from 7.75 percent to about 6.1. The cap rate saw none of it, because the cap rate never looks at the loan.
This is why most net-lease buyers finance, and why the loan is part of the deal rather than a detail bolted on at the end. Around 60 percent of value is a common starting point. The right amount of debt is the amount that lifts the cash-on-cash return without thinning the coverage to where one soft year puts you at risk. That balance is a choice you make, and the cap rate has no opinion on it.
Two more numbers worth knowing
Debt-service coverage is the bank margin of safety, and quietly yours. It is net operating income divided by the loan payment. At 1.0 the rent exactly covers the payment, with nothing to spare. Institutional net-lease deals usually run between 1.5 and 2.5, which means the rent covers the payment with real room. The wider that margin, the more of a soft year you can absorb before the loan becomes the problem.
Internal rate of return is the whole-hold number. It rolls every year of cash flow together with the eventual sale and the loan payoff into one annualized figure. It is the most complete measure of a levered return, and the most sensitive to assumptions, which is why it should always travel with the assumptions that produced it.
The cap rate is how the building is priced. Cash-on-cash is what the building pays you.
The dollar walk
One number can hide a lot. The most honest view is not a single yield at all. It is the dollar walk, the year-by-year trace of what the deal puts in your pocket from year one through the year the loan comes due and the building sells. It shows the soft years and the strong ones, the refinance, and the exit, in actual dollars. A cap rate is a snapshot taken by the seller. The dollar walk is the movie, and you are in it.
- All dollar figures above are illustrations at the stated assumptions, not a specific property.
- The amortizing payment is computed at 6.5 percent over a 30-year schedule on the stated balance.