The three sources of return
- Cash flow. Rent minus operating expenses and the mortgage payment. This is the part you can spend.
- Loan paydown. Each payment retires a little principal, paid for by your tenant. It is small in the early years and grows every year.
- Appreciation. The change in the property’s value. With a 25% down payment, a 3% rise in value is a 12% gain on your down payment. That is leverage working in your favor; it works the same way in reverse.
Total return = (cash flow + loan paydown + appreciation) ÷ cash invested
How to read the result
Cash-on-cash return counts only the first source. Total return counts all three, which is why it is usually much higher. Be careful how much weight you put on it: cash flow is the only part that is predictable and spendable. Loan paydown is locked in the property until you sell or refinance, and appreciation is a forecast.
A property with strong total return and negative cash flow is a bet on appreciation that you have to fund every month.
Beyond year one
Returns change over a hold. Rents rise, the loan balance falls faster, and selling costs take a share at the end. The internal rate of return over the full hold period captures all of that in a single annual figure.