Rental Property Cash Flow Formula and Cash-on-Cash Return

Rental property cash flow is what is left after every real cost of owning and operating the property is subtracted from the rent it collects, including the mortgage payment. Investors who skip straight from gross rent to a profit estimate almost always overstate their return, because vacancy, management, maintenance, and reserves quietly eat 25% to 35% of gross rent before the mortgage payment is even considered. This guide walks the full formula with a worked duplex example, using real numbers at every step.

From gross rent to NOI

Net operating income (NOI) is the property's income before debt service. The formula:

NOI = Effective Gross Income − Operating Expenses

where Effective Gross Income (EGI) is gross rent minus vacancy loss, and operating expenses cover everything required to run the property except the mortgage.

Worked example: a duplex, two units at $1,500 a month each.

Operating expenses, as a percent of EGI unless noted:

The capex reserve is the line most beginner analyses skip. It is not a real bill this year, but a roof, a water heater, or a parking lot does not last forever, and setting aside 5% of EGI now is cheaper than a surprise $12,000 special assessment on your own cash flow later.

Debt service, with the PMT formula written out

Debt service is the mortgage payment. The standard amortization formula:

M = P × [r(1 + r)^n] / [(1 + r)^n − 1]

where P is the loan amount, r is the monthly interest rate (annual rate divided by 12), and n is the total number of monthly payments.

Worked example, continued: 25% down on the $350,000 duplex means a loan of $262,500. At a 7% annual rate over 30 years, r = 0.07 / 12 = 0.005833 and n = 360.

In Excel this is =PMT(rate/12, nper, -loan_amount), which returns the same number without doing the algebra by hand. The formula above is what that function is computing. Keep the cents. If you round the payment to $1,746 first, the annual figure comes out $5 low, and on a deal this thin that is 0.3% of the year's cash flow gone missing for no reason.

Cash flow

Cash Flow = NOI − Annual Debt Service

That is a thin margin on a $350,000 property, and it is a realistic one. This is the number most listing sites never show you, because they stop at gross rent or, at best, NOI.

Cap rate, cash-on-cash return, and DSCR

These three ratios answer different questions, and mixing them up is the most common analysis mistake in rental investing.

Cap rate, a measure of the property's return independent of financing: Cap Rate = NOI / Purchase Price

Cash-on-cash return, the actual return on the cash you put in: Cash-on-Cash = Annual Cash Flow / Total Cash Invested

Total cash invested is the down payment plus closing costs. Here, $87,500 down plus roughly $7,000 in closing costs is $94,500.

DSCR (debt service coverage ratio), the metric your lender cares about most: DSCR = NOI / Annual Debt Service

Many lenders on rental loans that are underwritten on the property's income want a DSCR of 1.20 to 1.25 or higher. At 1.08, this deal at these terms would likely need a larger down payment, a lower purchase price, or higher rent. You can work out exactly how much larger the down payment has to be. Divide NOI by the target ratio to get the most debt service the lender will allow. Then turn that payment back into a loan amount with =PV():

That is $35,596 more cash at closing. It also changes cash-on-cash. Cash flow rises to $4,529 because the payment is smaller, and cash invested rises to $130,096 with the same $7,000 of closing costs, so cash-on-cash goes from 1.8% to 3.5%. A cap rate alone will never show you this constraint.

The 1% rule and the 50% rule, and when they mislead

The 1% rule says monthly rent should be at least 1% of the purchase price. Here, $3,000 / $350,000 = 0.86%, below the threshold. That correctly flags this as a thin deal, but the rule says nothing about financing terms, so two properties that both pass the 1% rule can have very different cash-on-cash returns depending on the interest rate and down payment.

The 50% rule says to assume operating expenses (excluding debt service) will run about 50% of gross rent. Applied here: 50% of $36,000 is $18,000. The actual operating expenses plus vacancy came to $11,556 + $1,800 = $13,356, or 37% of gross rent, well under the rule's assumption. If this investor had used the 50% rule instead of building the real expense line, NOI would come out at $18,000. That is $4,644 too low and below the $20,957 of debt service, so the deal would show a $2,957 yearly loss instead of a $1,687 gain. The error can run the other way too. In an older property with high maintenance costs, real expenses can top 50%, so the rule makes a bad deal look acceptable.

Both rules are fine for a 30-second first screen on a list of twenty properties. Neither should be the basis for an actual offer.

The 10-year view: appreciation, principal paydown, and why IRR is the honest number

Cash-on-cash return only measures the cash that comes out of the property each year. It ignores two of the three ways real estate actually builds wealth: appreciation and principal paydown.

Appreciation, assuming 3% annual growth on the $350,000 purchase price:

Principal paydown on the $262,500 loan at 7% over 30 years, after 120 payments:

Equity at year 10 = property value − remaining balance = 470,371 − 225,257 = $245,114

Against the original $94,500 of cash invested, that is a gain of about $150,600 in equity, on top of the $1,687 a year of cash flow collected along the way. Lay it out as a cash flow schedule. Year 0 is −94,500. Years 1 through 9 are 1,687 each. Year 10 is 1,687 plus the equity. Solve it with =IRR() and the deal returns 11.2% a year over the ten years.

That figure assumes you keep every dollar of equity when you sell, and you will not. Agent commissions, transfer taxes, and escrow on a sale usually run 5% to 8% of the price. At 6%, selling costs are $28,222, so the year-10 equity you actually receive drops to $216,891 and the IRR falls to 9.9%. Use the after-cost number. It is the one that matches what lands in your bank account.

The schedule also holds rent and expenses flat for ten years while the property value grows 3% a year. That is a conservative choice for cash flow. If rent and expenses both grow 3% a year, NOI grows 3% while the mortgage payment stays fixed. Cash flow then climbs from $1,687 in year 1 to $8,588 in year 10, and the after-cost IRR rises from 9.9% to about 12.0%. That 2-point gap comes from one assumption, so pick it on purpose and write it down next to the result.

That 9.9% IRR, not the 1.8% cash-on-cash return from year one, is the honest measure of the deal, because it is the only number that accounts for all three ways the investment actually pays: cash flow, principal paydown, and appreciation, each arriving on its own timeline.

Checklist

Before you make an offer on a rental property, confirm you have:

For a ready-built version of this entire workflow, gross rent through 10-year IRR, see a finished rental property analyzer.

Written with AI assistance and checked by recalculation. For education and planning only, not financial advice.