Cap Rate vs. Cash Flow: Which is the Right Metric for You?

One of the most important skills you can develop as a property investor is evaluating potential properties and determining – confidently – whether to add them to your portfolio. To do that, of course, you have to have not only a clear sense of mid- and long-term goals for your property investments but also a firm understanding of which metrics matter when evaluating the ROI potential of a property.

Two common metrics are cap rate and cash flow. Most property investors tend to favor one over the other, but in reality both may be useful as part of your big-picture portfolio management. Here, I’ll offer some insight into what these metrics measure and when it makes sense to use each.

Use Cap Rate to Measure Mid-Term Returns

Capitalization rate (“cap rate”) refers to the net operating income of a property divided by its purchase price. A broad rule of thumb is that you want your cap rate to be greater than the cost of your money. So if interest rates hover at 4%, you’ll want a cap rate to be higher than that.

In recent years, cap rates have been suppressed because of a combination of low interest rates, limited new inventory, and a steady stream of people wanting to buy.

Because of this, cap rates today often correlate with a property’s risk: Low cap rates typically mean a property has low risk (and will offer lower returns), while higher cap rates suggest the property comes with greater risks (such as being in a high-crime area or having a lot of deferred maintenance) but has a greater likelihood of delivering higher returns.

Of course, there are ways that savvy investors can increase a property’s listed cap rate. I’m guessing most people understand how to negotiate on purchase price, so the variable I’ll focus on is net operating income.

Here’s a simplified example: Imagine a property that costs $100,000 and rents for $500 per month, meaning its cap rate is 6% ($6,000 / $100,000). But let’s say this property has a garage and that parking in the area is scarce. If you decided to rent the garage for $100 per month, then you could quickly boost your cap rate from 6% to 7.2%, just by changing how you manage the property.

Similarly, you could add partitions to make a single-family property a duplex or make a two-bedroom a three-bedroom. You could shift the cost of utilities to tenants, if a building is metered separately.

As a mid-term investment, that’s a great way to ensure that the property’s earning you more than you paid to buy it. When you're considering new properties, use the listed cap rate as a starting point. Determine whether you can improve it by implementing different management strategies.

Use Cash Flow to Measure the Potential for Long-Term Income

Cash flow is a post-purchase metric. It measures the amount of cash an investor has after paying for everything else (insurance, taxes, interest, utilities, repairs, etc.). It’s common for cash flow to be negative in the early years of owning a property, but long-term investors are often okay with that.

In the long term, inflation comes into play, so an investor might buy a property with a negative cash flow knowing they’ll raise rent 3% every year to keep up with inflation. The key thing to remember is that acquiring property today tends to be lower-cost than acquiring property tomorrow, so cash flow may improve over the long term.

If you’re interested in investing in properties as a source of income over the long haul, you’ll want to focus on cash flow (and be sure that you won’t have to keep putting money into the property each month). But keep in mind: These two metrics aren’t entirely unrelated. Properties with high cap rates tend to have higher cash flow.

If you treat properties as a major income source, you may be willing to invest the time and energy in taking care of deferred maintenance or going through the process of evicting tenants every few years (as is more commonly necessary in properties with a high cap rate). For your trouble, you’ll likely see greater cash flow.

If you’re more interested in seeing returns on your income akin to what you’d see by investing in the stock market and are primarily interested in real estate for its potential to help you diversify your portfolio, you may not care to put as much legwork into property maintenance. In that case, low cash flow may be okay with you as long as your cap rate is reasonably healthy.

Not an Either/Or Proposition

While most property investors tend to rely more heavily on either cap rate or cash flow when evaluating potential properties, these metrics are by no means meant to be mutually exclusive. In fact, they can be combined into a sort of super-metric: cash-on-cash return. This metric measures the annual cash flow divided by the total cash put into the property and therefore more accurately depicts the rate of return on your investment. This ratio allows you to compare the opportunity with this rental property against other investment opportunities in front of you, particularly non real-estate opportunities. The idea should be that you choose the investment with the highest cash-on-cash return.

It’s smart to consider both when looking at a potential property, consider how that property might fit in with your larger portfolio and investment goals, and evaluate how much work you’re willing to put into maintaining it (and the rest of your properties) on a daily basis.