Calculating Return on a Rental Property: Cash Flow and Cash-on-Cash
Combine rent, costs and the mortgage to calculate pre-tax cash flow, cash-on-cash return, equity build-up and debt service coverage.
What you will learn
- How to calculate the yearly pre-tax cash flow of a financed rental property.
- What cash-on-cash return measures and what it leaves out.
- How to add equity build-up (repayment) for a fuller picture.
- How the debt service coverage ratio (DSCR) shows whether rent covers the loan.
Explanation
Lesson 5 ended with the net operating income (NOI): rent after non-recoverable costs and allowances, before financing. Now we add the mortgage from lesson 3.
Debt service and cash flow
Debt service (Kapitaldienst) is the total yearly loan payment: interest plus repayment. For an annuity loan it is the annual payment, loan × (rate + initial repayment rate).
Pre-tax cash flow = NOI − debt service
A negative cash flow means you must pay money into the property from your salary or savings every month. This is common in German cities with low yields. It is not automatically a bad investment, but you must be able and willing to carry it for many years, also if a tenant stops paying.
Cash-on-cash return
Cash-on-cash return = pre-tax cash flow ÷ equity invested
Equity invested is all your own money: down payment plus purchase costs (and any initial renovation). Cash-on-cash shows the yearly cash yield on your own money. It ignores two important things:
- Equity build-up: the repayment part of the debt service reduces your loan. It is cash that leaves your account but stays in your wealth.
- Value change: unknown until you sell, and it can be negative.
A fuller yearly measure, still excluding value change, is:
Return incl. equity build-up = (pre-tax cash flow + repayment) ÷ equity invested
This is equivalent to (NOI − interest) ÷ equity, the formula from lesson 1 without value change.
Debt service coverage ratio
DSCR = NOI ÷ debt service
A DSCR of 1.0 means the property's income exactly covers the loan payment. Below 1.0 the owner pays the difference. Professional lenders to investors often look for a DSCR clearly above 1.0, because it leaves a buffer for vacancies and repairs. For a private buyer, the bank also checks your personal income, so a DSCR below 1.0 can still be financed, but the risk sits with you.
Taxes
All figures here are pre-tax. In Germany, rental income is taxed, while interest, running costs and depreciation (AfA) are generally deductible. The result can differ a lot from the pre-tax picture; lesson 12 gives a general orientation. For your own case, check with a Steuerberater.
Worked example
Hypothetical example: a flat costs €200,000; purchase costs are €20,000 (10%). Annual cold rent is €10,800; non-recoverable costs and allowances are €2,400, so NOI = €8,400. The buyer pays €40,000 down plus the €20,000 costs, so equity invested = €60,000, and borrows €160,000 at 3.5% with 2% initial repayment, monthly payments. Excluded: taxes, value change, rent increases.
- Debt service: €160,000 × (3.5% + 2%) = €8,800 per year (€733.33 per month).
- Pre-tax cash flow: €8,400 − €8,800 = −€400 per year (about −€33 per month).
- Cash-on-cash: −€400 ÷ €60,000 ≈ −0.7%.
- Repayment in year 1 (month-by-month calculation): about €3,252; interest about €5,548.
- Return incl. equity build-up: (−€400 + €3,252) ÷ €60,000 = €2,852 ÷ €60,000 ≈ 4.8%.
- DSCR: €8,400 ÷ €8,800 ≈ 0.95.
Rate sensitivity: if the same loan cost 4.5% instead, debt service would be €160,000 × 6.5% = €10,400 and the cash flow −€2,000 per year. A one-point higher rate turns a small monthly gap of about €33 into about €167.
Common mistake
Practice activity
Use the same flat (NOI €8,400, purchase costs €20,000). This time the buyer pays a €50,000 down payment, so equity invested is €70,000 and the loan is €150,000 at 3.5% with 2% repayment. Year-1 repayment is about €3,049. Calculate debt service, pre-tax cash flow, cash-on-cash return, return including equity build-up and DSCR.
Show solution
- Debt service: €150,000 × 5.5% = €8,250.
- Cash flow: €8,400 − €8,250 = +€150.
- Cash-on-cash: €150 ÷ €70,000 ≈ 0.2%.
- Incl. equity build-up: (€150 + €3,049) ÷ €70,000 ≈ 4.6%.
- DSCR: €8,400 ÷ €8,250 ≈ 1.02.
More equity improves cash flow and DSCR, but the return including equity build-up falls slightly (4.8% to 4.6%), because more of your money earns only the property yield instead of the gap between yield and loan rate.
Limitations: one-year snapshot before tax; rent, costs and the interest rate after the fixed-rate period will change.
Key takeaways
- Pre-tax cash flow = NOI − debt service (interest plus repayment).
- Cash-on-cash measures the cash yield on all your own money, including purchase costs.
- Add the repayment to see equity build-up, but remember it is not cash you can spend.
- A DSCR below 1.0 means you support the property from your own income.
Next step
The next lesson looks at the risks behind these numbers: concentration, illiquidity and interest-rate changes.
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