Real estate investing for beginners can be challenging with all the new concepts and real estate metrics involved. A major challenge that most beginner real estate investors struggle with is evaluating the performance and profitability of existing or potential real estate investments. So, how can this problem be solved? Here comes the role of return on investment analysis. In this blog, we will talk about two valuable investment analysis tools: cap rate vs ROI. What’s the difference between both metrics and how should you utilize them for better investment decisions?
Both cap rate and return on investment (ROI) are important tools that are frequently used to evaluate the profitability of rental properties and your income potential. Cap rate vs ROI are often misunderstood and sometimes incorrectly used, even by expert real estate investors. Continue reading this blog to know the difference between cap rate vs ROI and how to calculate each of them.
Cap rate vs ROI: Calculating return on investment
Return on investment or ROI is a real estate investment tool that measures the return you receive on an investment compared to the initial cost of investment (down payment). Before demonstrating how to calculate return on investment, it is important to understand the following terms.
1- Net Operating Income (NOI): NOI is the annual income generated by a rental property minus the expenses incurred from operation. Note that net operating income does not include financing cost, a.k.a mortgage payments.
Example: A rental property is rented out for $1,000 per month with yearly maintenance costs of $500. Ignoring acquisition costs, broker commissions and potential vacancy costs, net operating income is calculated as follows:
NOI = ((12 X $1000) – ($500)) = $11,500
2- Cash Flow: It is the amount of profit after deducting mortgage payments from net operating income.
Now that you know the difference between NOI and cash flow, return on investment is simply calculated by dividing cash flow by the initial investment (down payment on the property).
- ROI = Cash Flow / Down Payment
Example:
Property price: $200,000
Down payment: 20% X $200,000 = $40,000
Yearly mortgage payment on 5% 25 year loan: around $12,000 (this value is estimated using a mortgage calculator like this one here).
Monthly rent: $2,000
Monthly expenses: $200
NOI: (12 x $2000) – (12 x $200) = $21,600
Cash flow: $21,600 – $12,000 = $9,600
ROI: $9,600/$40,000 = 0.24 or 24%
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What is a good ROI?
When it comes to answering this question, different real estate investors and experts will give you different answers as it all depends on investors’ preferences, type of investment property and of course, the location of the rental property. While some investors will be happy with a 6% ROI, others would not accept anything less than 20%. On average, we can say that a 15% ROI is a good real estate investment.
Related: What Is a Good Return on Real Estate Investment?
Cap rate vs ROI: Calculating cap rate
Cap rate or capitalization rate is another real estate investment tool used to determine the potential return of an investment based on the market value of the property. The main difference between cap rate vs ROI is that mortgage payments are not included when calculating cap rate. Therefore, the cap rate formula would look like this:
- Cap rate = NOI/ Property Price
Using the same example as above:
Cap rate = $21,600/$200,000 = 0.108 or 10.8%
Since the cap rate calculation measures the rate of return on an investment regardless of the financing method, it is typically preferred when comparing the performances of different real estate investments.
The use of cap rate is not limited to measuring the performance of a real estate investment. Cap rate is also used to valuate real estate properties to give investors an idea about the property’s value based on cap rates of real estate comps around a given investment opportunity. Moreover, cap rates indicate the level of risk associated with an investment property. In theory, the higher the cap rate is, the higher the level of risk. But what is a good cap rate?
Again, this question is subjective as cap rate varies depending on asset type and property market. Despite that there is no unanimous answer to this question, we advise to look for cap rates around 10%.
Related: What’s a Good Cap Rate for Investment Properties?
Cap rate vs ROI: What is the difference?
Looking at cap rate vs ROI, calculating both is a crucial step of return on investment analysis, but which one is more reliable when it comes to evaluating potential investment opportunities? The answer is cap rate, and we will show you why:
1- Cap rates reflect the true profitability of a rental property without taking into account the financing method. Therefore, cap rate shows us the property’s worth in comparison with the rental income it generates.
2- For financed properties, ROI calculation can vary per buyer since it depends on the financing terms. So, for the same investment property, there can be different ROIs. Thereby, we can conclude that ROI has more to do with the investor and how it affects him or her, whereas cap rate is more related to the investment property itself and how good or bad it can perform.
Related: Traditional Rental Strategy: Go for These Cities for Cap Rate
To learn more about the cap rate in residential real estate investing, watch our video:
The Bottom Line
Return on investment analysis is without a doubt the key to making smart real estate investment decisions. But for beginner real estate investors, it can be overwhelming with all the different tools available. One particular challenge is using cap rate vs ROI. Both investment tools are important- ROI measures how good the real estate investment deal is considering financing, whereas cap rate only measures how good the deal is neglecting financing.
One last piece of advice. If you really want to save your effort, time and money, then you should consider using an investment property calculator. Mashvisor’s revolutionary rental property calculator will not only provide you with important metrics like cap rate vs ROI, but it will also suggest which rental strategy is more suitable for a given investment property (traditional vs Airbnb rentals). There’s more! With Mashvisor, real estate investing has never been more simple and user-friendly. Our special heatmap analysis and Mashmeter score will tell you exactly where to find the best real estate investments.
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