What Real Estate Investors Should Know About Cap Rate vs ROI

In real estate investment, understanding basic financial measures is necessary to make sound decisions. Two of the most common measures are the capitalization rate (cap rate) and the return on investment (ROI). But what is the difference between cap rate vs ROI?

Both of these metrics indicate how profitable a property is based on real estate prices, yet they are calculated in different ways and are utilized for separate purposes. This article will explore the differences between cap rate and ROI, how they are derived, and how they are utilized in real estate investment analysis.

What is Cap Rate?

To start, let’s first discuss cap rate. Cap rate is a financial metric that is used to estimate the potential return on a real estate investment property based on its income. Cap rate assumes that the property is bought with cash and does not consider other means of financing.

Below is the cap rate formula:

Cap Rate = ^{NetOperatingIncome(NOI)}⁄_{Real Estate Value}  x  100

Net Operating Income (NOI) is your gross rental income minus all operating expenses (excluding mortgage payments).

The current market value is the market price or purchase price of the property.

Let’s look at a quick example to see how this formula works. Say that a rental property is priced at $500,000 and its NOI is $40,000. The formula for cap rate equation would be:

^40,000/_500,000 x 100 = 8%

This means that you would expect an 8% annual return based on rental income.

What is ROI?

Return on Investment (ROI) is a broader measure of profitability that considers how much money an investor really earns relative to how much they invest. In contrast to cap rate, ROI considers financing, mortgage repayments, and appreciation. It’s simple to calculate ROI, which is widely used to evaluate investments.

Below is the ROI formula:

ROI = ^{Annual Return}/_{Total Investment} x 100

Annual cash return is your net income and profit after mortgage payments.

Total investment is the actual amount of cash that’s invested, such as down payments, closing costs, repairs, etc.

An example of this equation in use is as follows. Imagine you purchase a property for $500,000 with a 20% down payment of $100,000. The property has an NOI of $40,000, and the mortgage payment adds up to $24,000 annually. The calculation would look like this:

ROI = ^16,000/_100,000 x 100 = 16%

The 16% ROI represents your return on the actual cash amount that was invested.

High vs Low Cap Rates

You may be wondering, “Is a high cap rate or a low cap rate better?” The answer depends on risk tolerance, market, and your own investment strategy. The return criteria for a higher cap rate usually is 9% or upward.

What a high cap rate means for property owners:

1. More dollar returns per dollar invested
2. Bigger risks associated with less desirable locations or with unstable tenant bases
3. Common in up-and-coming markets or fixer-upper properties that need extensive repairs

For example, a property that is in a lesser-developed market might have a 10% cap rate, which means that it has excellent income potential, but also at a higher risk of vacancy.

What a low cap rate means:

1. Lower dollar returns per each dollar invested
2. Provides more stability and usually in high-demand areas with stable rent levels
3. Normal in prime markets in major cities such as New York or Seattle

For example, a 4% cap rate property in New York City is likely in a desirable location, but it costs more in the short-term timeline, reducing the income-to-value ratio.

More risk and more reward result from higher cap rates, while less risk accompanies lower cap rates and stability.

High vs Low ROI

Whereas cap rate represents the potential income value of a property, ROI evaluates the overall profitability because it considers financing, leverage, and appreciation.

What a high ROI indicates:

1. Great cash flow and high financial lending
2. Implication of an investor who is borrowing effectively
3. May involve additional investment risks if too much debt is used

If you put down $20,000 for a property that has an annual cash flow of $6,000, this means that the ROI is 30%. This ROI is high, but potentially volatile if interest rates increase.

What a low ROI indicates:

1. Could be a sign of high closing costs or expensive financing fees
2. Could be more stable in the long term, especially if appreciation is included
3. Often found in markets where cash flow is lower, but property price values appreciate

Imagine that a home in San Francisco requires a $200,000 down payment but provides only $8,000 in annual returns. This would result in a 4% ROI, which is a low cash flow but could likely see an increase in value.

High returns are reflected in high ROI but will likely come with more risk. Low ROI are considered to be safer, but they can indicate cash flow challenges.

Cap Rate vs ROI

You should use cap rate when you are comparing similar properties within the same market to determine their income potential.

Using ROI is best when analyzing your actual investment return, including cash flow and appreciation.

The following table breaks down the basics of real estate investing with cap rate vs ROI:

	Cap Rate	ROI
Is Mortgage Included?	No	Yes
Is Cash Flow Measured?	Yes	Yes
Is Appreciation Considered?	No	Yes
What is it Best For?	Comparing similar properties	Assessing overall profitability
What are the Risk Factors?	Higher cap rate = higher risk	ROI varies based on leverage

When to Use Cap Rate vs ROI

Now that you understand cap rate vs ROI, let’s point out the most important distinguishers and key differences between using them.

You should use cap rate when:

1. Comparing similar income properties in the same market
2. Looking for cash flow-based investments
3. Looking at potential rental return before financing

You should use ROI when:

1. Considering leverage and financing on an investment
2. Looking at long-term profitability, including appreciation
3. Selecting the best use of capital in different deals

Smart property investors use both cap rate and ROI to make informed choices.

Understanding the Differences Between Cap Rate vs ROI

Both cap rate and ROI are essential to property investors. Cap rate helps you compare income properties before financing, and ROI measures your actual return on investment after considering financing and appreciation. Understanding the cap rate formula and how to interpret low and high cap rates and ROI will provide valuable insights into different properties and help you make the most profitable and informed possible decisions.