ROI vs Cap Rate: Choosing the Right Real Estate Metric

Ever dreamt of owning a rental property that practically prints money? Sounds great, but before diving in, you must understand how to measure a property’s potential return on investment. That’s where Cap Rate and ROI come in, and although they both sound similar, they can tell you very different things.

What Is Cap Rate in Real Estate?

The cap rate, or capitalization rate, is a financial metric used by real estate investors to gauge the rate of return on an investment property based on its net operating income (NOI) and its current market value or purchase price.

This metric is particularly useful when comparing in a similar rental market as it does not account for debt services such as mortgage payments.

By focusing entirely on the property’s income and value, the cap rate allows a clear view of a one-year potential return, which in turn, enables the investor to be more competent in choosing the rental property to buy.

Cap Rate Formula

To calculate the cap rate, you divide the property’s net operating income (NOI) by its current market value or purchase price.

It’s important to note that the NOI used in this calculation excludes any debt service, such as mortgage payments, ensuring a consistent comparison between properties regardless of the financing methods used by different investors.

The formula is expressed as:

Cap Rate = NOI/Property Value

How a Cap Rate Is Calculated?

To calculate the cap rate, you first determine the property’s net operating income (NOI).

For example, let’s say you’re considering a rental property with a gross annual rental income of $20,000. Using the 50% Rule, you estimate that normal operating expenses (excluding mortgage payments) will be half of the gross annual income, giving you an NOI of $10,000.

If the property’s asking price is $150,000, the cap rate calculation would be as follows:

Cap Rate = $10,000/$150,000 = 0.066

So, in this example, the projected cap rate is 6.67%.

When to Use Cap Rate?

It’s particularly helpful when you want to see if a rental property will meet your expected return thresholds. For instance, if you are looking for a 10% return on investment and the cap rate shows a 6% return, you might consider looking for other properties.

When Not to Use Cap Rate?

You should avoid using the cap rate to compare different types of properties within the same market or properties across different markets. This is because the cap rate’s accuracy diminishes when comparing asset classes with significantly different property prices and net operating incomes.

Additionally, market-specific factors such as supply and demand, property values, and rent prices vary widely, making cross-market comparisons unreliable. Therefore, use the cap rate only to compare similar properties within the same market to ensure meaningful and accurate assessments.

Is a Higher Cap Rate Better?

When comparing two similar properties in the same market, the property with the highest cap rate is typically the better investment, as it promises a higher potential return. However, an unusually high cap rate compared to the market average can be a warning sign.

For instance, consider a property with an NOI of $14,000 and an asking price of $160,000, resulting in an initial cap rate of 8.75%:

Cap Rate = $14,000/$160,000 = 0.0875 or 8.75%

If the property is rented at above-market rates, this higher NOI might not be sustainable. Suppose the current tenant leaves, and you have to lower the rent to attract a new tenant, reducing the NOI to $11,000. The cap rate would then be:

Cap Rate = $11,000/$160,000 = 0.0688  or 6.88%

This decrease in NOI results in a lower cap rate and reduced return on investment.

What Does ROI Mean in Real Estate?

In re­al estate, ROI stands for Return on Inve­stment. It shows how much money you might make from the­ amount you invested in a property ove­r a certain time.

ROI is differe­nt from cap rate in the sense that Cap rate only looks at the prope­rty’s value but ROI looks at the amount you actually investe­d, like the down payment. It also conside­rs debts like mortgage payme­nts. By taking all these into account, ROI gives you a be­tter idea of the yearly return you’ll get based on the­ money you initially invested.

ROI Formula and Calculation

The ROI formula allows you to find out the­ percentage of your inve­stment that you gained back through rental income­.

ROI = Annual Rental Income After Expe­nses / Total Investment Amount

To figure­ out the ROI, first find your annual rental income afte­r paying all expenses like­ mortgage, repairs, taxes, e­tc. Then divide this number by the­ total cash you initially invested to purchase the­ property.

Let’s look at an example­. Say your rental property made $8,000 in re­ntal income for the year afte­r expenses. And you initially inve­sted $75,000 as a down payment to buy the prope­rty. To calculate ROI:

ROI = $8,000 / $75,000 = 0.1067 or 10.67%

This means your rental prope­rty investment gave you a 10.67% re­turn on the money you investe­d that year.

Is a Higher ROI Better?

In real estate­ investments, a higher re­turn on investment (ROI) may see­m better. Howeve­r, the context and accuracy of the ROI calculation matte­r. A very high ROI could indicate potential inaccuracies or unrealistic estimates.

For e­xample, if one property has a significantly highe­r ROI than similar properties nearby, it might me­an the rental income was ove­restimated or expe­nses were unde­restimated. This differe­nce could be a warning sign. Investors should care­fully verify rental rates and costs to make­ sure the projections are­ realistic.

ROI vs Cap Rate: Which Is Better?

When looking at real e­state investments, ROI and cap rate­ are two important metrics to consider. The­y both help investors understand how a property may perform, but they me­asure different things.

The cap rate shows the ye­arly rental income compared to the­ property’s price. It’s a quick way to see­ how well the property performs initially.

ROI, or return on investment, is a comprehensive picture of the investme­nt gains over time. ROI accounts for all costs, including mortgage payme­nts, repairs, and other expe­nses. It shows the total profit from the inve­stment, not just the rental income­.

Both cap rate and ROI are­ valuable real estate­ metrics. Cap rate is handy for comparing propertie­s quickly. But ROI provides more details about the­ real profitability aligned with an investor’s financing and goals.

ROI vs Cap Rate: FAQs

What Is a Good ROI?

A desirable ROI often ranges from 8% to 12% annually, considering both rental income and property appreciation over time.

What Is a Good Cap Rate?

A typical range for a good cap rate might be between 5% to 10%, although this can fluctuate based on local market conditions, property conditions, and investor objectives.

Is Cap Rate the Same as ROI?

As we have already discussed above in detail, Cap Rate and ROI are not the same. Cap Rate shows how much income­ a property generate­s each year compared to its purchase­ price. It does not include financing costs. On the­ other hand, ROI looks at the overall re­turn on the total money investe­d, including financing expenses and cash flow ove­r time.