The Cap Rate and ROI are good starting points when comparing multiple potential investments. How're they calculated and how're they different?
The cap rate and ROI are two metrics that can be used by real estate investors to determine whether a property is a good or bad investment. In order to make the best possible financial decision when dealing with your rental property investments, you need to have as much information as possible.
However, while irrefutably valuable, these two terms are often confused or misused. In this article, we take a closer look at what each means, the related formulas, and the key differences between cap rate and ROI to help you use each to their best effect when making decisions regarding your investment property.
The cap rate is a good way to quickly calculate the potential of a property based on estimated numbers. The capitalization rate is a measurement of the rate of return on an investment property.
The lower the cap rate of a property the slower the return will be. It takes into account the total (expected) income and the property’s current market value. The cap rate formula is a good one to take into account when comparing like-for-like investments in a single market.
The ROI is generally used to measure a property’s performance as an investment. An ROI might be used for a fix and flip as well as long-term buy and hold investments. One of the key differences is that the ROI also factors in the cost of financing and is a way of determining a predicted percentage of return on investment.
NOI (Net Operating Income)
This is the annual cash income that the property generates minus general operating expenses such as general maintenance. It does not, however, include mortgage payments or depreciation – both of which may be deducted from tax to reduce the tax burden of the property.
The market value of a property is the current valuation of the property – essentially how much the property is likely to sell for at any one given time.
Cash flow is the amount of cash left over after every expense has been deducted from the property’s income. Unlike the ROI this includes mortgage payments.
The capitalization rate can be used in several ways. For example, when analyzing a potential investment you might calculate the cap rate of similar properties in the area, and using that data you could work out how much income you’d need to make that target cap rate happen.
Alternatively, you might have a cap rate in mind and calculate the cap rate of a property based on the numbers you have to see if this fits your investment strategy.
And finally, you can estimate how much is the upper limit you can spend on a particular property if you know the potential net operating income and the capitalization rate.
The formula for calculating the cap rate is:
This formula can be rearranged to calculate – as mentioned above – the net operating income as well as the market value of a property.
$10,000 NOI / Market Value $200,000 = 0.05 (or 5%) Cap Rate
On the flip side, you might know that similar properties in the area have a cap rate of around 8. As such you can rearrange the formula to work out the maximum you are willing to pay for the property.
$10,000 NOI / Cap Rate 8% (0.08) = A Market Value of $125,000
This would then be the upper bounds of what you’re willing to pay for that property.
The final use is to calculate the net operating income, and thus the amount of income the property would need to generate according to your target capitalization rate and the property’s market value.
8% (0.08) Cap Rate x Market Value $200,000 = A NOI of $16,000
Cap rates measure the potential risk and profitability of a property. The higher the cap rate the more profitable the property will be for you. However, determining the cap rate that you want also depends on the market and overall risk.
For example, in a busy central location, you would expect a lower capitalization rate. And, you might accept a lower rate if the property is in a quickly appreciating area. What is more, if the area has a high demand for renters and few rentals in it then you are likely to have very few vacancies. In comparison, a property in a country with low demand for renters has a higher risk, and you might look for a higher capitalization rate to mitigate this risk.
You need to consider that fair market rents, market values, property taxes, and operating expenses vary by neighborhood, city, and state. Because of this, a good cap rate for one market may very well be a bad cap rate for another market.
Many investors use the capitalization rate differently. Some will not even consider markets where they can’t get the rate they are looking for – others simply look for properties with cap rates that are high in respect to their risk levels and neighborhood. You will want to become familiar with cap rates of similar properties in the area and use that as a potential benchmark.
With this in mind, it’s generally agreed by experts that a good cap rate is between 8% and 12% with 8% being reasonable and 12% being very good.
The ROI (return on investment) of property measures the return. It takes into consideration the cash invested and the debt or mortgage used to purchase the property. Generally speaking, you can increase the ROI by increasing the debt – however, it is worth noting that over-leveraging can be risky.
The formula for calculating ROI is:
(NOI) $16,000 – (annual mortgage payment) $10,000 / $60,000 = 10%
However, if you only put in 20% (equalling $40,000) your ROI would equal:
(NOI) $16,000 – (annual mortgage payment) $10,000 / $40,000 = 15%
In theory, you want a higher ROI. However, aiming for the highest ROI can be a bit misleading as you could, for example, decrease your monthly mortgage payments to interest-only repayments to increase the ROI on paper. This though would mean you’re not building equity in the property, and you’ll end up paying more for your loan over time. This strategy also increases your exposure to financial risk.
Determining a good ROI then depends on a few factors. First, your investment strategy. Some investors with long-term strategies are happy to accept a slightly lower ROI so that they can build equity in an appreciating asset. Others with shorter-term goals might want something closer to 20% or 30% so that they can reinvest their cash at hand and scale their portfolios faster.
You also need to consider the type of property and the market that the property is in. One way to determine what ROI is good for you is to start with how the property will be financed. Once you know your down payment, interest rate, and loan terms you can then compare the ROIs on different investments to see which generates the highest return.
As with the cap rate, there’s no standard accepted number for a “good” ROI. However, experts recommend that investors aim for an ROI above 15%.
When it comes to analyzing potential investment properties both of these calculations offer very useful insights. Capitalization shows you what you should be paying for a property based on the rental income that you are expecting to generate through it. However, it doesn’t take into account mortgage payments and the power that leveraging offers.
On the other hand, ROI does factor in financing and gives you a comparison picture of money in vs money out. It doesn’t though, take into consideration equity and appreciation and depending on how you finance it, a single property could have several dramatically different ROIs.
Both the cap rate formula and ROI calculations are key tools to use when analyzing rental real estate. While cap rate measures what the rate of return on a rental property currently is or should be, ROI calculates what the return could be.
The cap rate and ROI are good starting points when comparing multiple potential investments. However, when making your final decisions you will likely want to drill down further into the numbers to get a more accurate picture of potential returns and possible risks of the investment.
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