When it comes to having long-term success while investing in real estate, having a solid understanding of the financial metrics involved is a critical aspect of reaching your goals. Two common indicators that often take center stage in any investment decisions you make are your capitalization rate (cap rate) and your return on investment (ROI).
If you need clarification on these property management terms, you’re not alone. While often confused with one another, cap rate and ROI are two different and distinct concepts.
In this blog post, we will go over everything you need to know about cap rates vs ROI, exploring how each one can provide any investor with unique insights regarding how an investment will perform and how profitable it will be in the long run.
We will go over how to calculate each metric, how they can help you understand the profitability of an investment, and what the ideal cap rate and ROI look like.
If used correctly, both the cap rate and ROI of an investment property can help you create a clearer picture of what its future may look like, and how it can help you reach your investment goals. So, if you’re ready to learn more about these key metrics, keep reading!
What Is a Cap Rate?
The capitalization rate, or cap rate, is a metric that exists to help real estate investors evaluate just how profitable a property will be in the long run, and how much risk is involved in the investment. Expressed as a percentage, a cap rate will measure the rate of return that an investor will consistently generate on one property.
This tool is also an excellent option to use when investors are comparing the profitability between multiple investments. A higher cap rate usually signifies a higher potential return, however, there may also be a higher level of risk involved.
A cap rate provides investors with a snapshot of the property’s expected return without taking financing or mortgage details into account.
What Is ROI?
Return on investment, or ROI, is a valuable metric for investors everywhere, and it is typically used to see how a rental property is performing. Similarly to the cap rate, your ROI is expressed as a percentage. But what makes it different from the cap rate?
Well, the ROI calculator is typically used for properties that are fixer-uppers or flipped and aren’t necessarily generating a consistent income on a regular basis. Also, unlike the cap rate, your ROI takes the cost of financing into account.
3 Crucial Financial Terms That You Need to Know
Before we cover the differences and similarities between a property’s cap rate and its ROI, there are some financial terms that you should be familiar with.
- Net operating income (NOI): Your NOI refers to the annual amount of cash that is generated from an investment property after you have deducted the costs that go into owning and operating a rental property. This metric does not take your mortgage payments or any non-cash expenses like depreciation into account.
- Cash flow: After you deduct your mortgage expense from your NOI, you will be left with your cash flow. Essentially, your cash flow is everything that you are left with at the end of the day after all of the bills and expenses have been paid.
- Market value: The market value of a property is the amount that it should be sold for at any given time. Note that the market value of a property can fluctuate over time.
Now that you are familiar with these basic terms related to the financial side of owning a rental property, let’s get into how you can calculate a property’s cap rate and ROI.
How Can I Calculate a Rental Property’s Cap Rate?
Calculating a cap rate for a rental property is more simple than you may think.
Basically, your cap rate will give you valuable insight into three different aspects of your rental property: the rate of return, how much income a rental property should generate based on the selling price, and what the market value of a rental property should be based on the amount of income it can generate.
When you are calculating a cap rate for a rental property, you will first need to know its NOI. Then you will divide the NOI by the property’s current market value. The result will then be converted into a percentage, which will be your cap rate.
In short, the formula for your cap rate is this:
Cap rate = NOI / market value
For example, if you have a $10,000 NOI and you divide it by a $125,000 market value, you get .08, or an 8% cap rate.
What Should the NOI Be Based on Your Cap Rate?
Similarly, you can also use a rental property’s cap rate to determine what the NOI of an investment should be. This is typically based on the asking price of the property and the cap rates for other similar properties that are in the same area. All you have to do is multiply the cap rate by the property’s asking price, and you will know the NOI.
For example, let’s say you come across a property for sale that has an asking price of $150,000. In a market where cap rates for other properties with similar features are generally sitting around 8%, the NOI should be:
8% cap rate X %150,000 asking price = 12,000 NOI
How Can I Determine the Market Value of a Property by Using Its Cap Rate?
If you know an investment property’s NOI and the general cap rate in the area, you will also be able to determine just what the market value should be for any property.
All you have to do is divide the NOI by the cap rate, and you will end up with the market value of the house.
Here is a formula using the example from above:
$12,000 NOI / .08 cap rate = $150,000 market value
What Is a Good Cap Rate?
The capitalization rate of an investment property ultimately measures the risk and reward of comparable investments in the same market. Cap rates are also highly influenced by the state of the real estate market and its supply and demand.
For example, let’s say you are looking at a two-bedroom house that is located in a neighborhood that primarily has houses with three or four bedrooms. This may be a property that is more difficult to find a tenant for, so the property’s cap rate will be higher. Essentially, you will be getting a higher cap rate for a property in exchange for taking the risk of investing in a smaller house than what is standard in that area.
Here is another example. Let’s say you are in a more urban neighborhood where one-bedroom apartments are in high demand. The cap rate will be lower, but it is more likely that you will be able to find a tenant, as there is such a high demand for this kind of property in the area.
Ultimately, this often means that the ideal cap rate is subjective and dependent on the market that you are in. Fair market rent, the market value of a property, taxes, and operating expenses will all vary from market to market and state to state, so a good cap rate in one area may be a bad one in another.
How Do I Calculate a Property’s ROI?
The ROI calculation will measure the total return that an investor will receive from a rental property. Unlike the cap rate, your ROI takes the invested cash or down payment and the mortgage of the property into consideration.
To calculate your ROI, you will need to begin by subtracting the property’s total expenses from the total rental income that the property generates. You will then be left with the property’s NOI.
Next, you will want to divide the NOI by the total amount invested into the property, including the downpayment and any additional upgrades or renovations. You will then be left with a number that you will convert into a percentage to reach your ROI.
For our example, let’s use the same figures that we were working with earlier when we determined that the $125,000 house has an NOI of $10,000. Let’s say that when purchasing the house, you paid 20% as a downpayment, which would come to $25,000.
You choose to finance the rest with an annual mortgage payment of $6,000, making your annual return $4,000. That means that your ROI calculations would look something like this:
$4,000 annual return / $25,000 total investment = .16 or 16% ROI
What Is a Good ROI?
Your ideal ROI will ultimately depend on your personal investment strategy and goals. It will also depend on the type of property you are looking to invest in and the market you are shopping around in. Some investors are content with a 10% ROI, while others need a 20% ROI to even consider purchasing a property.
One way that you can determine your ideal ROI is by choosing how you will finance the property. Once you have figured out what your down payment, interest rate, and loan terms will be, you can compare your ROI on different investments and determine which one will be the best for you.
How Can I Boost My ROI?
An investment property’s ROI can be boosted based on how it is financed.
Using the same property as before as an example, let’s say you purchased that $125,000 property with a $25,000 down payment. If you decided to use an interest-only loan instead of a loan that was fully amortized, your ROI would be boosted and it would look something like this:
$6,000 annual return ($10,000 NOI – $4,000 interest-only mortgage payment) / $25,000 total investment = .24 or 24% ROI
See? We were able to boost the ROI by 50% simply by changing the way that the property was financed. You can also boost the ROI of a property by lowering the down payment. Essentially, you are using the power of leverage in both cases to boost your investment’s ROI.
ROI vs Cap Rate: What’s a More Reliable Tool for Real Estate Investors?
For any real estate investor, both the cap rate and the ROI calculations play important roles in how you will be able to determine the profitability of an investment.
Your cap rate can show you what a property’s selling price should be based on the amount of rental income it will be able to generate long-term. However, your cap rate does not take the power of leverage into account.
A ROI calculation will take your financing costs into account. However, because the terms of a loan are primarily dependent on the borrower’s unique rules and circumstances, the same property can have entirely different ROIs depending on the investor’s plan for financing.
Bottom Line
In short, the cap rate measures what the return on an investment property currently is or should be. Your ROI tells you what your return has the potential to be. The best approach is to use both tools to inform your investing decisions, as this will produce the most accurate results for predicting the future of an investment.
By taking both of these metrics into account, we are confident that any investor will be able to make wise decisions that lead to success in real estate.
If you have any further questions regarding how to determine just how profitable an investment property can be, or any other real estate needs you may have, contact our team at Blanket today.
