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CAP RATE VS. ROI

The main difference between CAP rate and ROI is what the two metrics are used for. A cap rate is used to estimate the investor’s potential return on investment (ROI) before the cost of financing. ROI stands for Return on Invest and is calculated including the cost of financing. Both calculations are pre-tax. It it is important to remember the differences in how these measures are calculated when using them to analyze and compare different investment opportunities . In addition, neither CAP rate or ROI take into consideration the metrics that are considered with a Discounted Cash Flow Analysis such as future cash flows and discounting future cash flows back to present values  that cap rate and ROI serve a different purpose when analyzing a deal.

Return on investment is meant to give investors an objective percentage of how much they can expect to make a deal after any financing costs. For example, ROI is typically expressed as a percentage to estimate the investor’s potential return on their investment. CAP rate makes the a similar comparison before loans costs, while ROI looks at the similar comparison after loan costs. In either case, both allow an investor to compare the returns of  completely different assets. ROI and CAP rate are expressed as a percentage. These metrics enable an Investor to, compare the CAP rate of a 10 year buy and hold on a Office building to the CAP rate of a single tenant restaurant property.

The formula for ROI is; ROI = (Investment revenue- investment expenses) / investment cost.
The formula for CAP rate is;   Cap Rate = Net Operating Income / Acquisition Cost ( i.e. Purchase Price).

As evidenced in the formula, both CAP rate and Return on Investment yield are dependent on purchase price, operating costs. Only ROI also factors in the loan cost.

Below is our Quick CAP – ROI Calculator. This tool can assist investors in determining an offer price that will meet their investment objectives. You can use it to decide whether a property’s price is justified or to determine the selling price of a property you own.

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* Commercial Mortgage Calculator

Most investment properties are offered listing a CAP rate. Usually NOI is not used since that number is determined by the level of financing needed by each particular buyer. CAP rate allows investors to make investment comparisons that result in the same comparison for every buyer regardless of whether they are they are a cash or mortgage or land contract buyer. A CAP rate may be used to compare dis-similar investments. For example, an investor trying to compare the return on a Multi-Tenant Industrial property with a 10 year hold to a Retail Strip Center with a 20 year hold.

The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor’s potential return on their investment in the real estate market.

While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market it does not take into account leverage, the time value of money and future cash flows from property improvements, among other factors. There are no clear ranges for a good or bad cap rate, but higher is better. CAP rates vary depending on geography, the economy, the market and the type of asset class.

CAP rate is used by investors deciding whether or not to move forward with a given property. In some cases, it may also be used by investors preparing to sell a property. CAP and ROI are best used for income properties and may not be relevant in the purchase of a building to occupy or vacant land. Investors (or even landlords) should use cap rate when evaluating several property types, including:

  • Commercial Real Estate
  • Multifamily Rental Properties
  • Apartment Buildings
  • Single-Family Rental Homes or townhouses

CAP AND ROI rates are important because it can provide a look at the initial yield of an investment property. Both formulas compares the returns on different assets in relation to the purchase price of the investment. This formulas help the investor to focus on the profitability of the deal relative to other opportunities .

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