The formula
Rental property ROI is four numbers, not one. Your effective gross income is the monthly rent plus other monthly income times one minus the vacancy rate. Your net operating income is the annual effective gross income minus annual operating expenses — taxes, insurance, HOA, maintenance, but NOT the mortgage. Your cap rate is the NOI divided by the purchase price. And your cash-on-cash return is the annual cash flow divided by the cash you put in. Whichever of the four you are solving for, the same six steps decide it.
Step 1 — Start with the monthly rent and subtract a vacancy allowance
Start with the two numbers the calculation hangs on. In our worked example the monthly rent is $2,000.00 and the vacancy rate is 5% — a common starting point. The effective gross income is ($2,000.00 + $0.00) × (1 − 5%) = $1,900.00 a month, $22,800.00 a year. A 5% vacancy allowance means you assume the property sits empty about eighteen days a year; at 10% vacancy the effective gross income falls to $1,800.00 a month and the cash flow to $150.00 a month. Keep the numbers fixed — every later step uses these two, and changing one halfway through is how rental math goes wrong.
Step 2 — Subtract annual operating expenses to get net operating income
Your net operating income is the annual effective gross income minus annual operating expenses — taxes, insurance, HOA, maintenance, but NOT the mortgage. In our example the monthly operating expenses are $450.00, so the annual expenses are $5,400.00 and the NOI is $22,800.00 − $5,400.00 = $17,400.00 a year, $1,450.00 a month. The mortgage payment is NOT an operating expense — it comes out after NOI, in step 4. At $600.00 a month of operating expenses the NOI falls to $15,600.00; at $0.00 of operating expenses it is the full $22,800.00.
Step 3 — Divide NOI by the purchase price for the cap rate
The cap rate is the NOI divided by the purchase price times 100. In our example the cap rate is $17,400.00 ÷ $250,000.00 × 100 = 6.96%. The cap rate lets you compare properties of different sizes on equal footing: at a $200,000.00 purchase price the same rent gives an 8.70% cap rate, and the rent-to-price ratio hits 1.00% — the 1% rule. At a $2,400.00 rent the cap rate is 8.78%. The cap rate ignores financing entirely, which is why step 4 matters more than step 3.
Step 4 — Subtract the mortgage for the cash flow
The annual cash flow is the NOI minus annual mortgage payments, and the monthly cash flow is the annual cash flow divided by 12. In our example the monthly mortgage is $1,200.00, so the annual cash flow is $17,400.00 − $14,400.00 = $3,000.00 a year, $250.00 a month. At a $1,500.00 monthly mortgage the cash flow is −$600.00 a year, −$50.00 a month — the property loses money every month even though the cap rate is unchanged at 6.96%. With no mortgage at all the cash flow equals the NOI: $17,400.00 a year, $1,450.00 a month.
Step 5 — Divide by the cash you put in for the cash-on-cash return
The cash-on-cash return is the annual cash flow divided by the cash you actually put in — the down payment plus closing costs — times 100. In our example the down payment is 20% of $250,000.00 = $50,000.00, the closing costs are $5,000.00, so the cash invested is $55,000.00 and the cash-on-cash return is $3,000.00 ÷ $55,000.00 × 100 = 5.45%. At a $2,400.00 rent the cash-on-cash return is 13.75%; at a $2,500.00 rent it is 15.82%. A bigger down payment lowers this number — at 25% down the cash invested is $67,500.00 and the cash-on-cash return is 4.44% on the same cash flow.
Step 6 — Check the result against the calculator
Check your hand calculation against the rental property ROI calculator: a $250,000.00 property at $2,000.00 of rent gives a $50,000.00 down payment, $55,000.00 of cash invested, $1,900.00 a month of effective gross income, a $17,400.00 NOI, $250.00 a month of cash flow, a 6.96% cap rate, a 5.45% cash-on-cash return, and a 10.42 gross rent multiplier. If your hand calculation differs, check the vacancy allowance first — it is the number most people get wrong — then check that you kept the mortgage out of the NOI and out of the operating expenses.
The 1% rule, explained
The 1% rule says a rental should bring in monthly rent of at least 1% of its purchase price — a $250,000 property should rent for at least $2,500 a month. Our headline property rents for $2,000.00, a 0.80% rent-to-price ratio, below the rule — it only works because the mortgage is cheap relative to the rent. At $2,500.00 of rent the ratio is exactly 1.00%, the effective gross income is $2,375.00 a month, and the cash flow is $725.00 a month. The 1% rule is a screening shortcut, not a law: in expensive cities almost nothing passes it, and in cheap ones almost everything does.
The 50% rule, explained
The 50% rule says operating expenses — taxes, insurance, maintenance, vacancies — typically run about half of gross rent over the long term. In our example the gross rent is $24,000.00 a year and the operating expenses are $5,400.00 a year plus the 5% vacancy allowance, well under half — which is why the property cash-flows at all. The rule is a warning, not a budget: expenses are lumpy, and a new roof or a broken furnace lands in one year, not spread evenly.
Cap rate vs cash flow: why a high cap rate can still lose money
The cap rate ignores financing, so a high cap rate can still lose money every month. Our headline property has a 6.96% cap rate and clears $250.00 a month — but raise the mortgage to $1,500.00 a month and it loses $50.00 a month while the cap rate stays exactly 6.96%. The cap rate answers “how good is this property?”; the cash flow answers “how good is this property for me, with my loan?” Use the cap rate to compare properties and the cash flow to decide whether to buy.
What if the rent is $2,400?
A higher rent changes the answer without changing the method. At $2,400.00 of rent the effective gross income is $2,280.00 a month, $27,360.00 a year; the NOI is $21,960.00 and the cash flow is $7,560.00 a year, $630.00 a month — a cap rate of 8.78% and a 13.75% cash-on-cash return. At a $200,000.00 purchase price the cap rate is 8.70% and the rent-to-price ratio is 1.00%. The rent is the lever: $400.00 more rent a month is $380.00 more cash flow a month.