The four numbers every investor evaluates
Real estate investing looks complicated from outside, but at the numerical level it collapses to four key metrics: cap rate, cash-on-cash return, net operating income (NOI), and debt service coverage ratio (DSCR). Every property deal can be defended or killed with these four numbers and reasonable assumptions about expenses.
Net operating income (NOI)
NOI is the annual income the property throws off before debt service and taxes. Formula: NOI = Gross rent − vacancy − operating expenses.
Operating expenses include property tax, insurance, HOA, property management, maintenance, landscaping, utilities you pay as landlord, and any capital expense reserves. NOI specifically excludes mortgage payments and depreciation — those are financing and tax decisions, not operating ones.
Rookie mistake: forgetting vacancy (assume 5–8% for typical markets), maintenance reserves (1% of property value/year or 8–10% of rent), and capital expense reserves (another 5–10%). If you don't subtract these, your "positive cash flow" is fictional — you're just undercounting expenses.
Cap rate
Cap rate = NOI ÷ property price. It's the unlevered annual return of the property. A $400K property with $28K NOI has a 7% cap rate.
Cap rates vary by market, asset class, and condition:
- Class A stabilized in Tier 1 metros (NYC, SF, LA): 3–5%
- Class B in mid-market cities (Nashville, Austin, Denver): 5–7%
- Class C in smaller cities, working-class areas: 7–10%
- Value-add, rural, marginal submarkets: 10%+ (higher risk)
Higher cap rate ≠ better deal. Cap rate is inversely correlated with both growth potential and risk. A 10% cap rate deal in a shrinking market could lose to a 5% cap rate deal in Austin because the Austin property appreciates and rents rise faster.
Cash-on-cash return
Cash-on-cash = annual pre-tax cash flow ÷ total cash invested. Measures the leveraged return on your actual money. This is usually the number investors care about most because it accounts for the leverage (mortgage) that amplifies returns.
Typical targets:
- Minimum acceptable: 6–8% (beats risk-free rate with some margin for risk)
- Good: 8–12% (common for well-priced rentals in solid markets)
- Great: 12%+ (typically requires value-add, sub-market, or exceptional deal)
Cash-on-cash changes with leverage. Putting 20% down gives higher cash-on-cash than 40% down (same NOI, smaller cash investment) — but also higher risk. Put too little down and a couple of bad months wipe you out.
DSCR (debt service coverage ratio)
DSCR = NOI ÷ annual debt service (P&I). A DSCR of 1.25 means the property throws off 25% more income than it needs to service debt.
DSCR is critical for investors using DSCR loans — a mortgage product that underwrites based on the property's income rather than personal income. Most DSCR lenders require 1.15–1.25 minimum DSCR. Below that, the property doesn't qualify and you need a conventional investor loan.
Investor loan specifics (vs. owner-occupant)
- Down payment: 20–25% minimum (vs. 3–5% for owner-occupant)
- Rate: 0.5–1% higher than owner-occupant rates
- Reserves: lenders require 6+ months of PITI in reserves after closing
- Rental income: conventional lenders use 75% of market rent (the 25% haircut accounts for vacancy)
- Max properties: Fannie Mae caps you at 10 financed properties. Beyond that, you go to portfolio lenders, DSCR loans, or commercial.
The 50% rule for operating expenses
A useful back-of-envelope check: over the long run, operating expenses on a typical rental tend to equal 50% of gross rent (including vacancy, maintenance, management, taxes, insurance, CapEx reserves, but NOT debt service).
If your deal shows operating expenses under 35% of gross rent, you're probably underestimating something. 50% is a conservative assumption; pro formas that beat 50% need specific, defensible reasons (owner-occupied management, extremely new build, tenant pays utilities).
The 1% rule (nearly dead)
The classic "1% rule" says monthly rent should be at least 1% of purchase price. A $250K property should rent for $2,500/month. This rule held in most markets pre-2020 but rarely applies post-COVID in desirable areas — most solid properties come out to 0.5–0.8%.
In the Midwest and South, 1% properties still exist. In CA, NY, and most growth markets, 1% doesn't exist anymore. Adjust expectations by market rather than forcing the rule.
Depreciation and taxes
Real estate's hidden superpower: residential rental buildings depreciate over 27.5 years for tax purposes, even though the property usually appreciates in real life. On a $300K rental ($250K building, $50K land), that's ~$9,100/year of depreciation that offsets rental income on paper.
Combined with mortgage interest deductions, many rentals show a paper loss for tax purposes while generating real cash flow. Cost segregation studies can accelerate depreciation on larger properties for bigger year-one deductions. Depreciation is "recaptured" when you sell, unless you 1031 exchange into another investment property.
Common pro-forma mistakes
- Ignoring vacancy (assume at least 5%)
- Understating maintenance (older properties can run 12–15% of rent)
- Skipping CapEx reserves (roof every 25 years, HVAC every 15, etc.)
- Assuming rent increases that exceed historical inflation
- Underestimating property management time cost if self-managing
- Ignoring property tax reassessment at sale (common in CA, TX, FL)
Related calculators
Use our rental yield calculator for a simpler cash-flow view, the flip profit calculator for fix-and-flip math, and the Airbnb income calculator for short-term rental modeling.