ROI versus CAP Rate: What’s the difference?
ROI (Return on Investment) and CAP rate (Capitalization Rate) are valuable tools for determining how profitable your investment property is or will be. Though both calculations are similar, what they measure and how they are calculated are slightly different. ROI, or Return on Investment, measures the amount of return you receive on an investment relative to the cost of the investment and is displayed as a percentage. To understand how ROI is calculated, we must first understand what the terms Net Operating Income and Cash Flow are.
Net Operating Income (NOI) is the amount of profit derived from all income and expenses.
NOI = Yearly Gross Income – Yearly Gross Expenses
Cash Flow is the amount of profit derived from the Net Operating Income after mortgage payments.
Cash Flow = NOI – (Monthly Mortgage Payment x 12)
ROI is then calculated by dividing the return of an investment (cash flow), by the cost of the investment (down payment on property). In the case of real estate, ROI would be calculated as such:
ROI = Cash Flow / Down Payment
For example:
Assuming an 80% mortgage, a down payment of 20% on a $300,000 property would equal $60,000. The monthly yearly mortgage payment would equate to $13,651 (mortgage interest rates will vary). Assuming the property makes $35,000 a year (rent, laundry) and expenses total $8,500 (utilities, tax, insurance, maintenance) the NOI (Net Operating Income) would be $26,500. Therefore, the Cash Flow divided by the Mortgage Down Payment will yield a 21% Return on Investment.
ROI = (26,500 – 13,651) / 60,000
ROI = 0.21 or 21%
So how does ROI compare to CAP Rate? The Capitalization Rate (CAP Rate) is used to determine an investor’s potential return based on the current market value of the property (in other words, the price of property). The CAP Rate of an investment property is displayed as a percentage and differs from the ROI because it does not include mortgage payments. The CAP Rate is calculated by dividing the Net Operating Income by the Purchase Price.
CAP Rate = NOI / Price
When using the same example investment property as above: Assuming the NOI remains at $26,500 and the property was purchased at $300,000 the CAP Rate would be 8.8%.
NOI = 26,500 / 300,000
CAP Rate = 0.088 or 8.8%
As you can see, the ROI factors in the financing of the property, unlike CAP Rate. Therefore, CAP Rate is typically preferred to compare properties equally across the board. Investors tend to look for a CAP rate of 6-8% for properties that do not need to be renovated and 8-10% for properties that will need renovations or updates.