Cap Rate vs ROI: What's the Difference in Real Estate?
September 12, 2022
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Cap rate vs. ROI is a common debate when buying a rental property. Many factors play a role in both formulas, including the market value, operating income, and for the ROI, the mortgage, and the amount of cash invested.
What Is a Cap Rate?
The cap rate is a good calculation for comparing similar properties when deciding which rental property to purchase. The cap rate measures a property's net operating income and property value. It doesn't include any debt service (mortgage payments) and helps you understand the property's one-year rate of return based on the property value and net operating income.
When to Use or Not Use
The cap rate is a good way to determine the percentage of your investment (money invested in the home) you'll earn back in the first year. Keep in mind, though, that it uses the current net operating income to calculate the cap rate.
Using the cap rate, you can tell if a rental property will provide the expected return. For example, if you set a threshold for a 7% return on investment and the cap rate calculation determines a 5% return, you may want to look at other homes.
However, you should only use the cap rate to compare like properties in the same market. If you compare different asset classes in the same market, you won't get an accurate answer with the cap rate because the property prices and net operating income vary significantly.
Also, comparing properties in different markets isn't accurate either. Too many factors, such as supply and demand, investment property values, and market rent prices, affect the cap rate.
Only use this formula to compare apples-to-apples, so to speak.
Cap Rate Formula
The cap rate formula is simple. First, you need the property's net operating income minus any mortgages borrowed and the property value. Here's the formula:
Cap rate = NOI/Property value
How a Cap Rate Is Calculated
To calculate the cap rate, determine the property's current annual rental income and estimate 50% in operating expenses. This gives you the property's potential NOI. Next, look up the property's asking price.
Divide the NOI by the asking price to get the cap rate. Keep in mind, however, that the NOI may be inflated, so do your homework to determine if the NOI is average for the area.
What Is a Good Cap Rate?
A good cap rate depends on many factors, including the type of return on investment you want and the average for the area.
Typically, any cap rate over 4% is good, but it varies by area. Higher cap rates usually mean the rental property has a higher net operating income and cash flow, but not always. So again, look at the income details to ensure everything seems average for the area and nothing seems inflated.
What a Higher Cap Rate Means
If a cap rate calculation is high, the seller might have inflated the rental income or downplayed the operating expenses. For example, a current tenant pays more than the market value rent but doesn't renew the lease. The next tenant doesn't pay the inflated rental prices and instead pays the market rent. This can reduce your cap rate, giving you a lower return on investment than anticipated.
However, if you compare two similar properties and one has a higher cap rate than the other, the investment property with the higher cap rate might be the better investment. For example, if you compare two single-family residences in the same area, the one with the higher cap rate may be the better investment.
Example in Real Estate
Here's an example of how the cap rate calculation affects real estate investors.
Say, for example, you are comparing two rental properties. One seller is asking $125,000 and has an NOI of $15,000 per year; the other is asking $190,000 and an NOI of $20,000.
The cap rate on each home is:
$15,000/125,000 = 12%
$20,000/190,000 = 10.5%
However, if the rental income is inflated on the $190,000, it can change things. Say, for example, you find out the seller charged too much for rent, and the new tenant will only pay the market rent. This lowers your NOI to $15,000 and changes your cap rate to 7.8%, making the $125,000 investment property a better buy.
What Is ROI?
The ROI measures your return on investment or the return on the money you put into the property, which is the down payment.
The ROI calculation tells you the annual return you should expect on the property, given your initial investment. Unlike the cap rate formula, ROI includes all debts, including mortgage payments.
ROI helps you understand how different investment amounts can affect your return. Then, you can play around with the numbers to see if a larger down payment makes sense.
When to Use or Not Use
The ROI formula is best when you will leverage your investment. In other words, the ROI will tell you your expected annual return with the mortgage payments included if you aren't paying cash for the property.
The ROI formula considers the property's annual cash income and the total cash invested in the property.
Note that the annual cash income is after all expenses, including the mortgage payment, and the total cash invested is the money you put down on the home.
The formula is:
ROI = Annual cash return/Total investment
How ROI Is Calculated
To calculate ROI, you must first determine the cash flow. To do this, figure out the annual rental income and operating expenses, including mortgage payments. Make sure to include expenses such as utilities, property taxes, insurance, and property management fees.
Your cash flow is the money left from the rental income after accounting for the expenses. The amount invested is equal to the down payment made at closing.
Divide the annual cash return by the total investment. Again, like the cap rate, ensure the rental income isn't inflated or the operating expenses are not fully disclosed.
What Is a Good ROI?
Like the cap rate, a good ROI is subjective. However, most investors consider an ROI of 10% or higher good and an ROI of 15% or higher excellent.
You must decide your threshold and compare your options between investing in real estate and alternative investments.
What a Higher ROI Means
If an ROI seems too high, it could indicate that numbers aren't accurate. Compare the ROI of different properties in the same market. If one seems inflated, look closer at the rental income. Is it higher than the market rent? If not, look at the expenses. Are they lower than what you'd expect for the area?
It's usually a red flag when an ROI is much higher for one property than most others, and real estate investors should proceed cautiously.
Example in Real Estate
Here's an example of ROI.
Let's say you're buying a property for $120,000. You make a 20% down payment, and your annual cash return after the mortgage payment and other operating expenses is $17,000.
17,000/120,000 = 14%
Cap Rate vs ROI: Key Differences
There are a few critical differences between cap rate vs. ROI.
The cap rate formula considers only the net operating income; it doesn't consider the debt service needed to buy the property. The cap rate also considers the property value, not the amount you invest in the property. It's a good calculation when you're comparing properties and want to know which has the most potential.
The ROI considers the annual cash return AFTER mortgage payments and other operating expenses. It also looks at your cash investment, not the current market value.
The cap rate assumes a cash investment, making it an even playing field when comparing properties. The ROI compares your options when deciding how much to invest.
Is It Better to Use Cap Rate or ROI for Analyzing a Property?
Both the cap rate and ROI are essential when analyzing a property. The cap rate tells you what to expect from a property should you pay cash and puts all properties on the same playing field.
The ROI focuses on your individual investment based on how much you invest in the property and can guide you with your down payment.
Overall, the ROI is the most important calculation, but the cap rate is a great place to start and helps you narrow your options.
Limitations and Factors Affecting ROI vs. Cap Rate
The market and individual preferences affect both the cap rate and ROI. For example, a seller with a property charging higher than market rent will inflate the cap rate and ROI, falsely leading investors to believe they'll make more.
The cap rate doesn't consider the mortgage payment, which, as the ROI shows, greatly affects your returns, so the cap rate formula shouldn't be used alone but could help you make initial decisions.
What Does a 7.5% Or 10% Cap Rate Mean?
A 7.5% cap rate means you can expect a 7.5% return on the property value annually, and a 10% cap rate means you can expect a 10% return. Again, this is without any mortgage financing.
What Is a Good Cap Rate for a Rental Property?
A good cap rate is subjective, but on average, any cap rate over 4% is considered good. Find out the average cap rate in an area you're considering investing to decide what's right for you.
What Is a Good ROI for a Rental Property?
A good ROI is between 10% - 15%, but like the cap rate, it's subjective. Some investors may be okay with a lower ROI, and others might expect a higher return.
Does a Higher Cap Rate Mean Higher Return?
A higher cap rate usually signifies a higher risk. This means that you have a higher potential for loss. However, it may also mean you may experience a lower cap rate if the rent is inflated or the seller didn't correctly demonstrate other costs.
Is Cap Rate Same as ROI?
Cap rate and ROI are not the same. The cap rate is the expected return based on the property value, but the ROI is the return on your cash investment, not the market value.
Do You Want to Sell at a High or Low Cap Rate?
It's best to sell a property with an average cap rate for the area. It shows that you're charging average market rent and have average operating expenses on the property.
How Does Cap Rate Affect Value?
The higher a property's NOI is, the more it's worth, and vice versa. A property with a higher cap rate usually has a lower market value.
Deciding whether to use cap rate vs. ROI to compare properties is a big decision, but it's best to use both. For example, when you're looking to buy a rental property, you want to buy a property with average returns for the market, which also provides the best return on your investment. Learn more by signing up and visiting our blog.
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