What is the Difference Between Cap Rate and ROI?

What is the Difference Between Cap Rate and ROI? 

 

If you are new to real estate investing, there are many concepts and analytics that are associated with it that may seem confusing at first glance. Many new investors have trouble determining the profitability and performance of their investment properties, which are two factors that should absolutely be considered before committing to a property long-term. 

Ultimately, the more information and resources you have in regards to a potential real estate investment, the better. This way, you’ll be able to make the best decision possible to benefit you in the long run. So, what metrics should you use to help you predict the potential return from your investment properties?

Cap rate and return on investment (ROI) are two of the best real estate analysis tools that can be used to help you determine the profitability of your property investments.

Net Operating Income and Cash Flow

Before we dive into cap rate and return on investment, there are two terms that you should familiarize yourself with beforehand; net operating income (NOI) and cash flow.

Net operating income (NOI) is the annual cash income generated from an investment property after normal operating expenses have been deducted. NOI does not include principal and interest payments on loans, capital expenditures, depreciation, and amortization. To calculate your NOI, simply subtract your operating expenses from your real estate revenue. 

Cash flow is your annual cash income after deducting mortgage expenses from the net operating income. One way to think of cash flow is the amount of money you’re left with at the end of the day after all of your bills are paid.

What is Cap Rate?

Cap rate, also known as capitalization rate, is a financial metric used to calculate what the rate of return is expected to be on a real estate investment property. Cap rate describes the relationship between a property’s net operating income and its market value, and can help to identify specific information about an investment property. 

First, cap rate can identify the potential rate of return on a property assuming that it was purchased with cash. Cap rate can also measure the perceived risk associated with a potential rental property. A higher cap rate means that the market identifies more risk and demands higher returns.  A lower cap rate means that the market identifies lower risk so they are willing to accept a lower return. Lastly, depending on the inputs in the cap rate calculation, it can also be used to calculate the potential value of a property.

Cap rate is the most useful metric for assessing real estate investments for their profitability and potential return. The cap rate simply represents the yield of a property over a specified period of time assuming the property is purchased with cash. 

Formula for Calculating Cap Rate

The formula for cap rate is: Cap Rate = NOI / Property value

For example, say we have a property with a market value of $200,000 and a net operating income of $15,000. To determine the cap rate, we would use the following formula:

$15,000 NOI / $200,000 Property value = 0.075 or 7.5% cap rate

Remember that the cap rate equation is based on annual income, which means that the rate of the same property could differ from year to year.

Let’s say that a rental property wasn’t occupied for six months last year but was fully occupied this year. The cap rate for last year would be significantly lower than this year’s because last year’s NOI was lower due to a high vacancy rate.

You can also use the cap rate equation to determine a property’s market value. If you know the property’s NOI and the market cap rate, you can reverse the formula to find the market value.

$15,000 NOI / 7.5% (.075) cap rate = $200,000 market value

What is ROI?

ROI (return on investment) is used to assess how well a real estate investment is performing and shows the annual return that a real estate investor could expect on an investment property. ROI measures the amount of return on a particular investment, relative to the investment’s cost, and is often used to compare the efficiency of multiple investments side-by-side.

The ROI calculation can be used for fix-and-flip properties that aren’t generating income, as well as longer-term buy-and-hold investments that are already profitable. Unlike the cap rate calculation, ROI factors in the cost of financing.

ROI is one of the most used tools in real estate because of how versatile and simple it is. At its core, ROI can be used as a gauge of an investment’s long-term profitability.

One important factor to note is that ROI can be expressed as a positive or negative percentage. If the cash flow on an investment is positive, then the ROI will be a positive percentage. However, if the cash flow on an investment is negative then the ROI will be a negative percentage. 

Formula for Calculating ROI

The formula for calculating ROI is: ROI = Annual return / Total investment

So for example,  let’s say we have a $200,000 house with an NOI of $15,000 that we used earlier in our cap rate equation. If you put 25% down, or $50,000, and finance the rest with an annual mortgage payment of $8,000, your ROI would be:

$7,000 annual return ($15,000 NOI – $8,000 mortgage payment) / $50,000 total investment = .14 or 14% ROI

You can also increase, or “boost” your ROI by using different amounts of leverage. 

For example, if the $200,000 house was purchased with a $50,000 down payment and an interest only loan, as opposed to of a fully amortized loan, the increased ROI would be:

$9,000 annual return ($15,000 NOI – $6,000 interest only mortgage payment) / $50,000 total investment = .18 or 18% ROI

So, you can see how easily the ROI can increase by simply changing the way the property was financed. The ROI could also be boosted by making a lower down payment on the home.

When to Use Cap Rate and ROI

In real estate investing, cap rate proves most useful at two specific moments in the process, which are the very beginning and the very end.

At the beginning of the process, cap rate is useful as a tool to help determine which properties do and don’t meet an investor’s expected return criteria. Let’s say an investor requires a return of at least 10%. This would automatically remove any deals from their search that do not meet the cap rate of 10%. 

At the end of the process, the cap rate is useful to determine a property’s terminal value. For real estate investors, a pro forma is a report that gathers current or estimated income and expense data to project the net operating income and cash flow of a property.  In a pro forma, a real estate investor must project a property’s income and expenses over a multi-year holding period.  At the end of that holding period, NOI can be divided by the cap rate to determine the estimated market price of the property.  This price is an important input into total return calculations like Internal Rate of Return (IRR) and Net Present Value (NPV).

ROI is also a useful tool to determine whether or not potential real estate deals meet the investor’s return criteria. However, it is most useful as a way to measure the significance of debt on a property. The ROI can determine the amount of debt needed to meet certain return hurdles. If that amount of debt is more than a lender is willing to provide, it may be an indication that there is too much leverage in the deal at a purchase price.

What is a Good Cap Rate and ROI?

The answer to this question is extremely subjective and depends on your individual situation.  There is no set “good” cap rate or ROI number. Good is determined based on an investor’s risk tolerance and return criteria.  For example, a 15% annual ROI seems great, but if an investor is looking for 20%, it isn’t good enough. Similarly, if an investor wants a cap rate of 10%, they most likely won’t bend for 7%.

Each real estate investor should establish their own investment strategy for cap rate and ROI and use these metrics as key factors into their investment decision. Just remember that there is no objective number or percentage you should be set on, and it should center around your own personal investment goals.

Conclusion

In conclusion, cap rate and ROI can both serve as useful metric tools for a real estate investor and can be used in a variety of different ways. 

Cap rate is the easier formula to grasp, and it can quickly determine the rental income potential of an investment property. However, cap rate doesn’t account for the power of leverage.

On the other hand, ROI provides a much broader view of an investment property deal, and factors in all financing costs, all property expenses, and revenue streams. But, because loan terms can differ from borrower to borrower, the same property can have different ROIs.

While both cap rate and ROI have pros and cons, it is best to utilize them both to gather as much information as possible on a potential investment property to ensure that the purchase will benefit you in the long run.