Chapter 4: Deal math: NOI, cap rate, cash-on-cash, DSCR

The listing sheet for Marcus and Tina's $240,000 rental called it a "strong income property" and printed exactly one number: $1,950 a month in rent. Rent is an ingredient, and an ingredient is not a meal. Four numbers stand between that $1,950 and a sound decision, and the same four numbers price every income property in America, from this house to a 400-unit tower. By the end of this chapter you will be able to compute all four on any listing in about ten minutes, which is less time than most buyers spend choosing a paint color.

One ground rule before the math. Every figure below uses the honest expense stack this guide defends line by line in Chapter 5: 7% of rent for vacancy, 12% for maintenance and capital reserves, 8% of collected rent for management, and 1.7% of the purchase price each year for property tax and insurance. If those feel high, hold the objection until you finish Chapter 5. Those percentages are the difference between a spreadsheet and a brochure.

Net operating income: what the building earns

Net operating income (NOI) is the rent a property actually collects minus its operating expenses, before any mortgage payment. The mortgage stays out on purpose. The building earns what it earns whether you pay cash, borrow 75%, or inherit it from an aunt. NOI measures the building; financing measures you. Keeping the two separate is what lets you compare any two properties on equal footing.

Here is Marcus and Tina's house with every line traced:

That is $1,094 a month. The house "makes $1,950 a month" the way you make your gross salary: true on a flyer, smaller in a checking account.

Cap rate: the speedometer

The cap rate (short for capitalization rate) is NOI divided by price: $13,133 ÷ $240,000 = 5.5%. Read it as the yield the building itself produces with no loan involved. If Marcus and Tina paid all cash, the property would hand them roughly 5.5% a year on $240,000 before income tax.

The cap rate's real job is comparison. A 5.5% cap house and a 7% cap fourplex in the same city are priced differently for a reason, and the reason is almost always risk and effort: a rougher block, older systems, a thinner tenant pool, a harder exit. Markets set cap rates the way they set stock prices, so an unusually high cap rate on a listing is rarely a gift. Treat it as a question to answer, not a prize to claim.

You will also hear that cap rates are "compressing." Cap rate compression means buyers are paying more for the same NOI, which pushes the ratio down. Compression made sellers look brilliant from 2012 to 2021. When someone forecasts returns that quietly depend on caps compressing further, they are forecasting that future buyers will accept less, which is sometimes true and never guaranteed.

Cash flow: what is left after the bank

Now the loan comes back in. Debt service is the total of your loan payments for the year. Marcus and Tina put 25% down ($60,000) and borrowed $180,000 at 7.3% over 30 years, which costs $1,234 a month, or $14,808 a year.

Cash flow is NOI minus debt service: $13,133 − $14,808 = −$1,675 a year, about −$140 a month.

The number is negative, and this guide will not soften it. At 2026 prices and a 7.3% investor rate, a fairly bought single-family rental with 25% down often starts underwater on cash flow. The deal can still make sense, because cash flow is only one of the four ways a rental pays (Chapter 1 walks through all four on this same house): the tenant pays down about $1,725 of principal in year one, a 3% appreciation assumption adds $7,200 on paper, and depreciation shelters income at tax time (Chapter 13). But honest accounting calls year one what it is. Marcus and Tina pay about $140 a month for the privilege of holding the asset while those quieter returns accrue.

Time changes the picture, and you should compute how much. The mortgage payment is frozen for 30 years while rent is not. If rent grows 3% a year and expenses grow with it, this house crosses into positive cash flow around year five, and by year ten it clears about $194 a month. A negative year one is survivable when it is priced, reserved for, and expected to end. It is fatal when the buyer was promised $450 a month and budgeted accordingly, which is exactly the autopsy Chapter 5 performs.

Cash-on-cash: what your money earns

Cash-on-cash return (CoC) is annual cash flow divided by the cash you put into the deal. It answers the only question your money cares about: what is this year's yield on the dollars I parted with. Marcus and Tina invested $60,000 down plus $7,200 in closing costs, $67,200 total. (Chapter 3 showed their full wallet impact was $87,200, but the reserves and day-one repair fund remain their money, so the convention is to measure CoC on down payment, closing costs, and any upfront rehab.)

Their cash-on-cash: −$1,675 ÷ $67,200 = −2.5%.

A negative CoC means the property consumed cash this year rather than producing it. Cash-on-cash is the cleanest number for comparing a rental against any other use of the same dollars, and it is also the most short-sighted, because it sees none of the paydown, appreciation, or tax benefit. Use it as a snapshot of year-one oxygen, never as the whole verdict.

DSCR: the lender's number

DSCR (debt service coverage ratio) is NOI divided by debt service: $13,133 ÷ $14,808 = 0.89. A ratio of 1.0 means the building exactly pays its own loan. Lenders get comfortable around 1.20 to 1.25, which is a building that earns 20–25% more than it owes, with cushion for a bad month.

At 0.89, Marcus and Tina's house covers 89 cents of every mortgage dollar, and their paychecks cover the rest plus every surprise. They got their conventional loan anyway because investor conventional underwriting leans on the borrower's income, counting 75% of expected rent toward it (Chapter 6 covers the mechanics). A DSCR lender, who looks only at the property, would have declined this deal. That refusal is information. When the most unsentimental underwriter in the market concludes the building cannot carry itself, believe the arithmetic, even if you proceed for the other three returns with open eyes and full reserves.

The four numbers move together, and the fastest way to build intuition is to push them around yourself. The analyzer below starts loaded with Marcus and Tina's deal. Drop the rate to 6%, raise the rent $100, or pretend vacancy is zero like the flyer did, and watch all four numbers react.

The same four numbers at scale: Sofia's fourplex

Sofia is buying her fourth property, a $650,000 fourplex in a working-class neighborhood where each unit rents for $1,800. Same arithmetic, bigger machine:

Her cap rate: $52,506 ÷ $650,000 = 8.1%. Her financing is a DSCR loan at 8.0% (she is self-employed; Chapter 6 explains why that matters). At 20% down, the $520,000 loan would cost $3,816 a month, $45,792 a year, for a DSCR of $52,506 ÷ $45,792 = 1.15, below her lender's 1.20 floor. At 25% down, the $487,500 loan costs $3,577 a month, $42,924 a year, and the ratio clears: $52,506 ÷ $42,924 = 1.22. The down payment was not her choice; the ratio chose it for her.

Her cash flow: $52,506 − $42,924 = $9,582 a year, about $800 a month. Her cash-on-cash on $162,500 down plus $13,000 closing: $9,582 ÷ $175,500 = 5.5%.

Notice what scale changed and what it did not. Sofia's cap rate is 8.1% against Marcus and Tina's 5.5%, and that is the market talking, not magic: her neighborhood is rougher, her building is older, and fourplexes trade at higher yields because fewer buyers want four sets of tenants under one roof. The structure helps too. One vacancy in her building cuts income 25%, not 100%. And the high cap rate is no accident given her loan: an 8% mortgage only pencils on a building that out-earns it, so DSCR lending pushes borrowers toward exactly these higher-yield, higher-effort properties.

When each number lies

Each of the four numbers fails in a known direction. Knowing the failure modes is most of the skill.

• Cap rate lies when NOI is fiction. A seller's pro forma (the marketing spreadsheet of projected income) routinely omits vacancy, management, and reserves. The flyer cap rate on Marcus and Tina's house was 8.4%; the honest one is 5.5%, and both numbers describe the same building. Never accept a cap rate you did not compute from your own expense stack.
• Cash-on-cash lies about time. Year one on this house is −2.5%. By year ten, with 3% rent growth against a frozen payment, cash flow is about $194 a month, a 3.5% CoC on the original $67,200, and paydown plus appreciation sit on top, invisible to the ratio. Judging a 30-year hold by its first-year CoC is judging a marathon at the first water station.
• Cash flow lies when capex lives outside the spreadsheet. A deal that "cash flows $300 a month" while reserving nothing for the roof is borrowing from a future year. One $8,000 furnace erases 27 of those months.
• DSCR lies when the numerator is padded. Some quotes divide gross rent by the payment: $23,400 ÷ $14,808 = 1.58 looks splendid and means little. Ask what is in the ratio. NOI over total debt service is the version that protects you.

Key takeaways

• NOI is rent minus operating expenses, before the mortgage: $13,133 a year on the $240,000 house. It measures the building, not your financing.
• Cap rate is NOI divided by price ($13,133 ÷ $240,000 = 5.5%) and exists for comparison; unusually high caps are priced warnings, not gifts.
• Cash flow is NOI minus debt service: −$1,675 a year here, because a 7.3% loan outruns a 5.5% building. Cash-on-cash (−2.5% on $67,200) tells you what your dollars earned this year and nothing else.
• DSCR is NOI divided by debt service. At 0.89 this house cannot pay its own loan; lenders want 1.20–1.25, which is why Sofia's fourplex needed 25% down to reach 1.22.
• Each number lies in a known direction: caps lie on fake NOI, CoC ignores time and the other three returns, cash flow lies without capex, DSCR lies on gross rent. Recompute everything yourself.

Sources: Fannie Mae Eligibility Matrix · Finvest Home Buying Guide · Finvest Personal Finance Guide