After consulting for a long time, I often encounter cases where people confuse cap rates with cash on cash returns. Recently, someone looking to rent out a single-family home in Rochester thought that since the cap rate was around 3 percent, they would achieve that level of return even with a mortgage. In the past, this misunderstanding wasn't a major issue, but in today's environment, where loan conditions significantly impact returns, distinguishing between the two has become more important.

The three main points to check in order are as follows. First is the overall return. The average home value in Rochester is around $252,000 (Zillow), and the median rent is $1,400 per month (Zillow). Dividing the annual rental income of $16,800 by the purchase price gives an overall return of 6.7 percent, which is quite high within New York State.

Second is the cap rate. The effective property tax rate in Rochester is 2.43 percent, which is higher than the New York State median of 1.9 percent (according to rochesterrealestateblog.com). For a property priced at $252,000, the annual property tax alone would be $6,124, which exceeds 36 percent of the annual rental income. Adding insurance, maintenance costs, and vacancy losses, and estimating the net operating income using the 50 percent rule, the annual figure comes to about $8,400, bringing the cap rate down to around 3.3 percent.

Third is the cash on cash return. This is a figure calculated only when a loan is used. For example, if you put down 25 percent of the purchase price, which is $63,000, and cover the remaining $189,000 with a 30-year fixed-rate mortgage, assuming an interest rate of around 7 percent, the monthly principal and interest payment would exceed approximately $1,250, resulting in an annual payment of around $15,000. Subtracting this payment from the net operating income of $8,400 could lead to a negative cash flow before taxes. While the cap rate of 3.3 percent looks good, it means that the cash on cash return could tell a completely different story depending on loan conditions.

In this case, increasing the down payment ratio from 25 percent to 35 percent to reduce the loan principal could lower the annual principal and interest payments, potentially turning the cash flow positive. Conversely, minimizing the down payment to maximize leverage could worsen the cash on cash return. In the past, low interest rates made these differences less pronounced, but now, the down payment ratio can often determine whether cash flow is positive or negative.

To break down the items to check into four categories, they are as follows. First is the overall return, which involves understanding the rent level relative to the purchase price in broad terms. Second is the cap rate, which confirms the profitability of the property itself after deducting operating costs, including property taxes. Third is the cash on cash return reflecting loan conditions, and fourth is the total return, including appreciation and loan principal repayment. If you only look at the cap rate, you risk hastily judging it as a good investment. In markets like Rochester, where purchase prices are low, it is easy to skip this order, so it is even more necessary to develop the habit of checking each item one by one.

To summarize the items to check:

• First, confirm the overall return relative to the purchase price based on annual rental income.
• Calculate the cap rate using net operating income after deducting operating costs, including property taxes.
• Reconfirm actual cash flow with cash on cash return, factoring in loan principal repayments.

In areas like Rochester, where purchase prices are low but property tax rates are high, the gap between cap rates and cash on cash returns can be larger than expected. Loan conditions vary based on individual credit and timing, so it is more accurate to recalculate after receiving a loan estimate. It is also important to note that the total return perspective, considering appreciation, can yield different results. This article is not investment advice, and it is recommended to consult with a real estate professional and loan officer before finalizing any contracts.