Cap Rate? ROI? Are you looking at a property investment and hearing these terms for the first time?
When you’re just starting out in real estate, there can be a lot of new words and concepts.
If you’re getting a bit confused, we don’t blame you!
In this blog, we’re going to cover two investment analysis tools you should know about: cap rate and ROI rate.
Read on for everything you should know about how to use them to make better investment decisions!
1. What is a cap rate?
A cap rate, the shortened form of capitalization rate, is a financial metric used by investors to calculate what the rate of return from an investment is based on the net operating income the property currently should produce and the property’s value or price.
The formula is:
Cap Rate = Net Operating Income / Property Value
The cap rate calculation should only be used to compare similar properties in the same market or submarket for two reasons:
2. What information is revealed about a potential investment property when calculating the cap rate?
When you calculate the cap rate, you learn the following:
A higher cap rate means that the market sees more risk and demands higher returns.
A lower cap rate means that the market sees lower risk, so they are willing to accept a lower return.
This is particularly helpful when trying to estimate purchase and sales prices in a pro forma.
3. When should you use the cap rate?
Each sector of the real estate market will have a defined market cap rate at any given time.
This is the average rate that a specific type of real estate is seeing in a specific area, and it helps buyers and sellers understand market valuations.
Here’s an example: A property owners want to list their multifamily property.
The current market cap rate for a Class B apartment complex is 7%.
They can use the cap rate formula to help them derive the current market value.
If the NOI is $87,500, then the property should be listed for $1.25 million ($87,500 / 7% = property value).
The cap rate is helpful in determining how good of a deal an investor is getting in relation to the market.
For example, if the market dictates a 7% cap rate, but the investor is able to purchase the property at 11%, then they’re getting a higher portion of income for their investment.
Ultimately, a higher cap rate means that an investor is achieving a higher return.
That said, this also means that the buyer is taking on more risk with the property.
Just note that the cap rate assumes the value and rate based on the full purchase price of the property.
It doesn’t take into consideration financing or the investor’s portion of the investment, which is likely far less than the total purchase price.
4. What is a good cap rate?
A property with an 5% to 10% cap rate is considered a good rate.
Having said this, there are numerous parameters that help determine what a good rate include:
Above, we gave the range of 8 to 12 percent as being “good.”
However, a 4 percent may be the normal cap rate in high-demand, high-cost areas like New York City or Los Angeles.
On the other hand, lower-demand areas or rural neighborhoods may see average rates of 10 percent or higher.
When you first purchase a property, you’d ideally want the rent to be as high as possible.
This will cause the net operating income (NOI) to increase and give you a higher cap rate.
The NOI is calculated by subtracting operating expenses from the total revenues of a property.
Unfortunately, most investors will look at the rental income at its present value.
Instead, you want to determine the cap rate once you add value to the property.
This could mean replacing roofs, mowing the lawn, or doing any other work that could help you increase rents.
When you increase the rent, you increase the cap rate.
Unless you’re buying top-tier properties, you’ll likely be doing some renovating.
Once you’ve done this value-added work, the goal will be to charge higher rents and reduce your vacancy rate.
To predict what rent and vacancy rates will be in the future, investors will use a rent pro forma.
This is a detailed breakdown of the income and expenses of a rental property once it’s fully stabilized and operating at peak efficiency.
With the cap rate calculation, determining what is “good” has a lot to do with risk tolerance.
To illustrate this, we’ll use an example.
There are two investments.
One has a 5% cap rate and the other has a 7% cap rate.
The property with a 5% cap rate may be a good fit for an investor looking for a passive and stable investment.
While it has a better location, it has a lower chance of rapid future appreciation.
The second property with the 7% rate is a better fit for an investor that’s willing to take more of a risk.
This risk, however, comes with a reward.
This is a less stable option with a greater potential upside for appreciation.
5. What is ROI?
ROI stands for return on investment.
It is the percentage return an investment achieves on an annual basis using the net income divided by the initial investment.
The formula used to calculate ROI is:
Return on Investment = Annual Cash Return / Total Cash Invested
Here’s an example of how to calculate the ROI:
If a rental property produces $200 after operating costs and mortgage payment are deducted, and the investor paid $18,000 to purchase the property, the cash return would be 13.3%.
This is how the math breaks down: $200 x 12 = $2,400 annual income / $18,000 acquisition cost = 13.3% ROI
6. When should you use ROI?
The ROI formula is not only used in residential and commercial real estate, but it’s also used in other investments when cash flow is produced.
This is because it’s an easy metric to evaluate the annual rate of return that an investment produces.
When there is a higher rate of return, it takes less time for your money to be returned to you.
In other words, you make more money.
When there is a lower rate of return, it takes longer for your money to be returned to you.
7. What is a good ROI?
Depending on who you ask, you’ll get a different answer.
It ultimately depends on the different real estate investors’ or experts’ preferences as well as the type of investment property and the location of the rental property.
Some investors will be happy with a 6% ROI while others will not accept anything less than 20%.
This is quite a big range, so think of 15% ROI as a nice average for a good real estate investment.
8. What are the differences between a cap rate and ROI?
Both the cap rate and ROI are essential for evaluating any potential investment opportunities.
Generally speaking, cap rate is more reliable when it comes to evaluating two or more potential investment opportunities, and this is due to some of the core differences between cap rate and ROI.
Here they are:
As such, cap rate shows the property’s worth in comparison with the rental income it generates.
Thus, for the same investment property, there can be different ROIs.
From this, we can conclude that ROI has more to do with the investor and how it impacts him/her compared to the cap rate, which is more related to the investment property itself and how well/poorly it can perform.
9. Is cap rate or ROI better when analyzing a property?
Both the cap rate and ROI are used to demonstrate different values in the marketplace.
As a result, it can be difficult to say which is superior to the other.
The cap rate is primarily tied to the value of real estate.
On the other hand, ROI is directly related to the investor’s personal return on investment based on the money that they’ve invested into a property.
If you’re currently looking at a new investment opportunity, use both cap rate and ROI.
Both are easy to calculate.
Knowing which is a better indicator of the value of an investment to an investor really depends on several factors.
For instance, if you currently have $20,000 that you wish to invest, and you’re trying to compare the return of two different investment classes based on the income they produce, we recommend using ROI.
However, if you’re looking at two different apartment complexes in the same area, one with a 5% cap rate and the other with an 8% cap rate, then you’ll easily be able to see which is a better return for your money.
These two metrics (while similar) simply have different uses in different investment scenarios.
10. Why is cap rate important?
Here are some reasons that cap rate is an essential valuation calculation:
Holding all else constant, whichever property is generating the most income will have the highest cap rate, and you’ll know which one to purchase.
All you have to do is divide 100 by the cap rate (ex: For a property whose rate is 10%, you’d be looking at a 10-year payback period). Note: this doesn’t including financing.
Performing a return-on-investment analysis is the key to making smart real estate investment decisions.
However, you may find it challenging to choose between these two metrics — cap rate and ROI — initially.
Cap rate measures the performance of the building itself while neglecting the type of financing it uses.
ROI measures how good the real estate investment deal is while considering the type of financing it uses.
They’re both important investment tools that you must use in different situations.
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.