The more information you have about a potential rental property investment, the better decision you’ll be able to make. Two of the metrics most frequently used by real estate investors are cap rate and ROI.
Unfortunately, these terms are often confused and misused, even by experienced investors. In this article, we’ll discuss the difference between cap rate and ROI, and how each formula can be used when analyzing investment real estate.
Definition of Cap Rate and ROI
Cap rate (capitalization rate) measures the rate of return on a rental property.
The cap rate calculation is used with income-producing properties and doesn’t factor in mortgage payments. The cap rate formula is also a good tool to use when comparing similar properties in the same market.
ROI (return on investment) is used to monitor how well an investment is performing.
The ROI calculation can be used for rehab and fix-and-flip properties that aren’t generating income, and longer-term buy-and-hold investments that are cash flowing. Unlike the cap rate calculation, ROI factors in the cost of financing.
Before we begin: Three important financial terms to know
There are three important terms to understand before you begin calculating the cap rate or ROI of a rental property:
- Net operating income (NOI) – the annual cash income generated from a rental property after normal operating expenses have been deducted. NOI doesn’t include deductions for a mortgage payment or non-cash expenses like depreciation that are used to reduce an investor’s taxable income.
- Cash flow – the annual cash income after deducting mortgage expense from the NOI. A good way to think of cash flow is how much money you’re left with at the end of the day after all of your bills are paid.
- Market value – what a property should sell for at a given point in time. Note that market value isn’t always the same thing as market price, because a specific property might be worth more (or less) to one investor than another.
Now that we’ve got these basic rental property metrics covered, let’s look at how to calculate cap rate and ROI, and the best uses for each formula.
How to Calculate a Rental Property’s Cap Rate
The cap rate formula measures three things:
- Rental property rate of return
- How much income a property should be generating based on the asking price
- What the market value of a property should be based on its income
Cap rate formula
Capitalization rate = NOI / Market value
- $10,000 NOI / $125,000 market value = .08 or 8% cap rate
Keep in mind that the cap rate formula is based on annual income. Because of this, the cap rate of the same property may vary from year to year.
For example, if a rental was vacant for three months last year but fully occupied this year, the cap rate for last year would be lower vs. this year. That’s because last year’s NOI was lower due to a high vacancy rate.
What The NOI Should Be Based on Cap Rate
You can also use the cap rate formula to determine what the NOI of a rental property should be based on the asking price and the cap rates for similar properties in the same market:
- 8% (.08) market cap rate x $125,000 asking price = $10,000 NOI
Here’s another way to look at the calculation. If you see a house for sale with an asking price of $150,000 in a market where cap rates for similar properties are 8%, the NOI should be:
- 8% cap rate x $150,000 asking price = $12,000 should be the NOI, everything else being equal
Determining Market Value with Cap Rate
If you know a property’s NOI and the going market cap rate you can also determine the market value of a house:
- $12,000 NOI / 8% (.08) cap rate = $150,000 market value
What is a Good Cap Rate?
Cap rates measure the risk and potential profitability of comparable properties in the same market area. Capitalization rates are also influenced by supply and demand.
For example, a two-bedroom house in a neighborhood with three- and four-bedroom houses will probably be harder to rent, so the property cap rate will be higher. In other words, you’re receiving a higher cap rate in exchange for taking the risk of buying a smaller house in an area where bigger homes are the norm.
Now, consider an urban area where one-bedroom rentals are in short supply and high demand from single, white collar workers. The cap rate would be lower compared to a larger property that doesn’t match the target tenant for the market.
Fair market rents, market values, property taxes, and operating expenses vary by neighborhood, city, and state. Because of this, a good cap rate for one market will be a bad cap rate for another market.
A great way to start getting familiar with market cap rates is by looking at rental houses for sale on the Roofstock marketplace. You’ll get a good feel for what single-family investments offer in different areas. Next, determine the average cap rate for the markets you want to invest in based on your investment strategy.
How to Calculate ROI for a Rental Property
The ROI (return on investment) measures your total return on an investment property. ROI considers two things:
- Cash invested or the down payment made
- Debt or mortgage used to purchase the property
ROI Formula
ROI = Annual return / Total investment
To calculate ROI, let’s use the same $125,000 house with an NOI of $10,000 that we used to calculate cap rate. If you put 20% down – or $25,000 – and finance the rest with an annual mortgage payment of $6,000 your ROI would be:
- $4,000 annual return ($10,000 NOI - $6,000 mortgage payment) / $25,000 total investment = .16 or 16% ROI
How to “Juice” The ROI
An ROI can be ‘juiced’ or boosted based on how a property is financed.
For example, if the $125,000 house was purchased with a $25,000 down payment and an interest only loan instead of a fully amortized loan, the juiced ROI would be:
- $6,000 annual return ($10,000 NOI - $4,000 interest only mortgage payment) / $25,000 total investment = .24 or 24% ROI
We increased the ROI by 50% by changing the way the property was financed. The ROI could also be juiced by making a lower down payment. In both cases, you’re using the power of leverage.
What is a Good ROI?
What makes a good ROI varies based on individual investment strategy, type of property, and the market the rental property is in. Some investors are happy with a 10% ROI, while others investing for the short-term won’t buy a property unless the ROI is 20%, 30%, or more.
One way to determine what ROI is good for you is to start with how the property will be financed. Once you know your down payment, interest rate, and loan terms you can then compare the ROIs on different investments to see which generates the highest return.
Is It Better to Use Cap Rate or ROI?
Both the cap rate formula and ROI calculation play an important part in analyzing a potential rental property investment.
Capitalization rate shows you what a property should be worth based on the rental income generated. But cap rate doesn’t take into account the power of leverage.
ROI factors in financing and the power of using other peoples’ money or OPM. However, because loan terms can vary based on each borrower, the same property can have dramatically different ROIs.
Bonus Tips on Using Cap Rate and ROI
It can be a little confusing for investors to know which financial calculation to use when analyzing rental property. Here are three bonus tips on how to best use cap rate and ROI formulas:
#1 Cap rates are good for comparing similar properties in the same market.
For example, single-family rentals in a high-demand West Coast market like San Francisco may have a market cap rate of less than 4%. In the Southeast, rental property in a smaller market like Birmingham, Alabama provides a market cap rate of 8% or more.
This doesn’t mean that one market is better or worse than the other. It simply means that each market has its own unique real estate investing dynamics.
#2 Use the same calculations to make an ‘apples-to-apples’ comparison.
Be consistent in how you crunch the numbers. Looking at the cap rate for one property and the ROI for another can lead to missed opportunities or investing mistakes. A cap rate could be low because of a higher-than-normal vacancy rate, while an ROI could be high due to the way the property is financed.
#3 Combining calculations produces the most accurate results.
There’s no rule that says you can’t use more than one metric when analyzing and comparing single-family rental property. Using both cap rate and ROI to analyze a deal can help you make the right investment decision.
Key takeaways for cap rate formula and ROI calculations
Roofstock makes it easy to conduct side-by-side comparisons of single-family rental homes in various markets throughout the U.S. to choose the right investment property for your portfolio. You can drill down on specific property financial performance, analyze neighborhood statistics, and even get help with financing.
Sometimes you’ll hear investors claim that using cap rate to measure income-producing property is better than ROI, or vice versa. The fact is that both the cap rate formula and ROI calculations are key tools to use when analyzing the performance of rental real estate.
While cap rate measures what the rate of return on a rental property currently is or should be, ROI calculates what the return could be.
- Cap rate measures the rate of return on rental property based on NOI before financing expense.
- Cap rates vary based on property type and market.
- Cap rate formula can also be used to calculate what NOI and market value should be.
- ROI measures the total return of an investment factoring in leverage.
- ROI for the same property will vary depending on how it is financed, while property cap rate stays the same for every buyer.
