Cap Rate vs ROI - Whats The Difference

Cap Rate vs ROI – What’s The Difference?

March 4, 2022

Produced by:
Richard Stevens

Richard Stevens is an active real estate investor with over 8 years of industry experience. He specializes in researching topics that appeal to real estate investors and building calculators that can help property investors understand the expected costs and returns when executing real estate deals.

Quick Summary

  • Cap Rate = Net Operating Income / Property Value
  • ROI = Annual Return / Total Amount Invested * 100

Table of Contens

What Is The Difference Between Cap Rate And ROI?

Cap Rate is great for completing a quick cash flow analysis of comparable properties, without factoring debt into the equation.

Cap Rate allows real estate investors to quickly assess the one year rate of return of an investment property, using only net operating income and the value of the property.

ROI allows investors to calculate how much money they get back, for every dollar they put in to an investment property.

ROI is excellent for determining how your investment property will grow over time, relative to how much you put down.

Definining Each Term

Cap Rate Definition: Cap Rate is short for Capitalization Rate. In real estate, the Cap Rate formula calculates the expected rate of return on a rental property, based on the net operating income, and the property value. When dealing with investment property, cap rate effectively measures what percentage of the capital (price paid for house) you will earn back over a one year period. 

  • If the cap rate is 5%, you can expect to earn 5% back on the capital paid
  • If the cape rate is 10%, you can expect to earn 10% back on the capital paid

This is why a higher cap rate trumps a lower cap rate, provided the risk profiles of the properties being compared are the same. 

ROI Definition: ROI stands for Return on Investment. The ROI formula takes the total amount invested, and calculates what percent will be returned to the investor on an annual basis. If the investment property is cash flow positive, the ROI is expressed as a positive percentage. However, if the investment is cash flow negative, the ROI is expressed as a negative percentage. 

In almost all cases, a higher return on investment trumps a lower return on investment, assuming the risk profile of the investment properties are comparable. 

Cap Rate vs ROI - Key Differences

Cap Rate Key Features

  • Cap Rate Formula = Net Operating Income / Property Value
  • Cap rate calculation doesn’t include mortgage payments
  • Cap Rate is unaffected by the amount of money that you put down
  • Cap Rate doesn’t factor in the financing arrangement between the borrower and the lender

ROI Key Features

  • ROI Formula = Annual Return / Total Investment Amount * 100
  • ROI does include mortgage payments (if you make use of a home loan)
  • ROI is greatly affected by the amount of money you put down
  • ROI is also influenced by the financing arrangement between the borrower and the lender

What Is The Cap Rate Formula?

Cap Rate = Net Operating Income / Property Value

It should be clear that you only need to know 2 key variables in order to work out the cap rate, namely net operating income and the property value. It’s worth clarifying exactly what each term means. 

Net Operating Income = Annual Rental Income – Annual Property Expenses (Excluding Mortgage Costs)

Property Value = The current market value of the property. This should be a realistic estimate of what you think the property would sell for when you run the calculation. If you aren’t sure of the current value, this arv calculator may help. It provides the selling price of comparable properties in the area.

How To Calculate A Rental Property's Cap Rate

Example Using $250,000 Rental Property

Step 1 - Workout the Net Operating Income

Step 2 - Insert the Numbers into the Cap Rate Formula:

  • Cap Rate = NOI / Property Value
  • Cap Rate = $20,000/$250,000
  • Cap Rate = 8%

As you can see, the property in this example has a capitalization rate of 8%. This represents the percentage of the capital ($250,000) that you will earn back over a 1 year period. You can learn more about how to calculate cap rate in this article

Alternatively you can make use of our simple Cap Rate Calculator to work out the numbers for a property deal that you are analyzing.

What Is the ROI Formula?

ROI Formula For Rental Property = Annual Return / Total Amount Invested * 100

As you can see, the ROI formula isn’t overly complicated, but it’s worth stating what each variable really means, when dealing with a rental property specifically.

  • Annual Return = Annual Revenue – Annual Expenses 
  • Total Amount Invested = The Down Payment on the Property 

Crucially, the ROI Formula for rental properties accounts for financing costs, and all other expenses connected to the home such as closing costs, property insurance, property tax, and utilities.

How To Calculate A Rental Property's ROI

ROI Example using $250,000 Rental Property

To help demonstrate how to use the ROI formula, let’s make use of a simple example. We are going to assume the investor will make a $50,000 down payment and make use of a mortgage, mainly because this is the most common scenario.

Step 1: Work out the annual revenue

  • Total Annual Rental Income = $32,400

Step 2: Work out the annual expenses

Step 3: Insert the numbers into the ROI Formula

As we mentioned earlier, we are going to assume the investor in this case is going to make a down payment. 20% is a realistic down payment to make, which works out to $50,000 (20% of $250,000 property). 

It’s plain to see that this particular property deal would generate an annual ROI of 24%. Naturally the final number for your investment property will be affected by the financing agreement, the property expenses, and the down payment that you can afford.

Lastly, to easily work out the numbers for your own rental property deal, our free rental property calculator may prove helpful. It does all the heavy lifting for you, and it works out the results for every year that you decide to hold the property.

Final Thoughts

It should be pretty clear that cap rate and ROI both have their place in a property investor’s toolkit. Cap rate is the simpler formula to work with, and it provides a quick way to gauge the rental income potential of an investment property. 

Conversely, working out the ROI provides a more holistic view of a property deal, factoring in all revenue streams, all property expenses, and financing costs. 

Generally, most investors will use both formulas when analyzing a deal. Cap Rate will come in handy during the property research phase. Having a concrete understanding of the ROI will be very useful when you are ready to pull the trigger on the deal.

Frequently Asked Questions (FAQ)

Does cap rate include mortgage costs?

No. The cap rate formula excludes financing costs entirely. You simply need to know the annual rental income, the annual property expenses (excluding the mortgage), and the property value. 

What is a good cap rate for a rental property?

If all other things are equal, properties with higher cap rates tend to be more desirable to investors, provided their primary focus is maximizing rental income. To further illustrate, consider the cap rate comparison table below.

Cap Rate Comparison Table New Silver

As you can see, the higher the cap rate, the higher the net operating income. This will ultimately result in better cash flow for the investor. Provided the risk profiles of the properties are the same, it’s clear to see that the cap rate can be used to help you choose between properties when making an investment decision.

Is higher cap rate better?

If the risk profiles of the properties that you are analyzing are the same, a higher cap rate is definitely better. A higher cap rate literally means that the net operating income is greater relative to the price of the property. 

To put it another way, if you are analyzing two similar rental properties in exactly the same suburb, worth roughly the same amount, the property with the higher cap rate would be more profitable and produce the highest return. 

With that being said, cap rate isn’t just used to compare extremely similar properties, which means it can be used as a tool to assess real estate investing risks. Broadly speaking, the lower the cap rate, the lower the risk, and the higher the cap rate, the higher the risk associated with the property. 

What does a 10% cap rate mean?

A 10 % cap rate means that you will earn 10% back on the capital paid for the property, over a one year period. So if you were to purchase a $300,000 house with a 10 % cap rate, the annual return would be $30,000. 

What does cap rate tell you?

Simply put, cap rate tells you much money a property will yield over one year, relative to the market value of the home. It is a real estate ratio that can help you assess the expected cash flow of a property, without the need to factor debt into the equation. This makes it very useful for comparing the expected rental income of different investment properties. 

How does cap rate affect value?

Cap rate doesn’t affect value. Rather, a property’s cap rate is determined by the market value of the property and the net operating income.

With that being said, you can workout the value of a property if you already have the cap rate, and the net operating income. This is ultimately just a different way of using the formula, where the property value is the unknown variable (rather than the cap rate). 

Follow New Silver