Two of the most useful financial metrics real estate investors use to forecast the potential return from rental property are cap rate and ROI. One calculation measures what the return could be, while the other calculates what the return is or should be.
In this article, we’ll take an in-depth look at how cap rate and ROI work, and explain why both metrics are important to use before investing in rental real estate.
What is a Cap Rate?
Capitalization rate – or cap 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 or should produce and the property value or price.
The cap rate calculation should only be used to compare similar properties in the same market or submarket for two main reasons.
First, income and property prices vary between asset classes – such as residential rental property versus office buildings. Cap rates also are different from city to city for the same property type, due to factors such as supply and demand, people working from home instead of commuting into the office, and real estate prices in general.
For example, the cap rate from a residential rental property in the San Francisco Bay Area might be much lower than the cap rate from a house in Nashville, because housing prices are extremely high in California versus a lower cost of living area like Tennessee.
Cap rate formula
The cap rate formula divides the net operating income (NOI) that a property generates before debt service (P&I) by the property value or asking price:
- Cap Rate = NOI / Property Value
Debt such as a mortgage payment is excluded from the cap rate calculation to make an apples-to-apples comparison because some investors will use more leverage than others, and vice versa.
How a cap rate is calculated
Assume you’re looking at a rental property with a gross annual rental income of $18,000 per year. Based on the 50% Rule, you anticipate that your normal operating expenses (excluding the mortgage payment) will be half of your gross annual income. That means your NOI will be $9,000 per year.
If the property has an asking price of $120,000 your projected cap rate will be 7.5%:
- NOI / Property Price = Cap Rate
- $9,000 NOI / $120,000 Property Price = 0.075 or 7.5%
What a higher cap rate means
When comparing two more similar properties in the same market to invest in, the property with the highest cap rate will be the better investment because your potential return is higher, everything else being equal.
However, if you see a property with a cap rate much higher than the going market cap rate, it could be a red flag.
For example, if a home is rented at an above-market rent the cap rate will be higher because the NOI is higher. But if the current tenant doesn’t renew the lease because the rent is too high and you have to lower the rent for a new tenant, your cap rate and return will be lower.
Let’s say you originally purchase a property with an NOI of $12,000 for the asking price of $150,000. Twelve months later, assume you have to lower the rent for a new tenant. If your NOI decreases due to a lower rent, your cap rate and return from the investment will also be lower:
- Current tenant: $12,000 NOI / $150,000 Property Price = 0.08 or 8%
- New tenant: $10,000 NOI / $150,000 Property Price = 0.067 or 6.7%
Even worse, the value of the property you recently purchased will go down, because your NOI has decreased. Let’s look at how to use the cap rate formula to calculate what the property value should be, and what the NOI should be.
Other uses for the cap rate formula
The cap rate formula can also be used to calculate what the NOI of a property should be and what the property value should be, as long as you know two of the three variables in the cap rate formula.
In the previous section we said that if the NOI on the property you purchased for $150,000 decreases, the property value will decrease as well. Here’s how you would calculate the change in property value assuming the going cap rate in the market for similar properties is 7.2%:
- Cap Rate = NOI / Property Value
- Property Value = NOI / Cap rate
- $10,000 NOI / 7.2% Cap Rate = $138,889 Property Value
In other words, your property value just declined by over $11,000 because you purchased the property rented to a tenant paying above-market rent and they did not renew the lease.
You can also use the cap rate formula to determine what the NOI should be based on the property value and the market cap rate. Let’s assume you’re looking at the same property with an asking price of $150,000. You know that the going cap rate for similar properties in the same market is 7.2%. Based on that information, you also know that the realistic NOI generated by the property should be $10,800:
- Cap Rate = NOI / Property Value
- NOI = Property Value x Cap Rate
- $150,000 Property Price x 7.2% Cap Rate = $10,800 NOI
Now that you know that the realistic NOI for the property is $10,800 and not $12,000, your next step is to ask the seller why. Maybe the seller’s answer will make sense. If not, you might be better off looking at another potential real estate investment.
What is ROI?
ROI – or return on investment – tells you what the percentage return on an investment could be over a certain period of time. Unlike the cap rate calculation, the ROI formula includes debt service and the amount of money you used to purchase the property instead of the entire property value.
ROI formula
The ROI formula divides the annual cash your rental property is generating after operating expenses and the mortgage payment by the total amount of money you invested:
- ROI = Annual Return / Total Investment
Once you’ve narrowed down alternative investment options using the cap rate formula, you can use the ROI formula to calculate what your return could be for each property.
How ROI is calculated
Assume you’re thinking about buying a property with an asking price of $120,000 that generates an NOI (before debt service) of $9,000.
If you use a conservative down payment of 25%, your total investment would be $30,000 and your annual return would be $4,420 after factoring in the mortgage payment (P&I). Based on this information, your ROI would be 14.73%:
- ROI = Annual Return / Total Investment
- $4,420 Annual Return / $30,000 Total Investment = 0.1473 or 14.73%
What a higher ROI means
If you’ve allocated $30,000 to invest in a rental property, then the property with the ROI will generally be the best investment. Of course, you’ll still need to make sure the current rent is at market and that the property operating expenses won’t increase after you purchase the property, due to items such as deferred maintenance.
You can also increase your ROI by using different amounts of leverage. Here’s what the ROI on the same $120,000 property would look like based on a down payment of 25%, 15%, and 10%:
Down Payment Total Investment Annual Return ROI
25% $30,000 $4,420 14.73%
15% $18,000 $3,804 21.13%
10% $12,000 $3,504 29.2%
For an investor focused on maximizing ROI, the lower the down payment is the better, even though the annual return on the cash invested is lower. However, it’s a good idea not to use too much leverage when investing in a rental property.
That’s because if your loan-to-value (LTV) on an investment property is too high, you’ll have trouble getting a loan at a good interest rate. Also, you could have negative cash flow if there are unexpected repairs or it takes longer than expected to find a new tenant to rent the home.
Which is Better – Cap Rate or ROI?
There’s no rule that says you have to choose between cap rate and ROI. That’s why the most successful real estate investors use both financial metrics to select the best property to invest in.
Both calculations are easy to do. Cap rate tells you what the return from an income property currently is or should be, while ROI tells you what the return on investment could be over a certain period of time.
If you’re considering two potential investments, the one with the higher cap rate could be the better choice. On the other hand, if you’ve allocated a certain amount of money for an investment, you can use the ROI calculation to see which property will produce more income based on your initial investment.
Final Thoughts
For beginning real estate investors the different concepts and financial metrics used to value rental property can be confusing at first. Two of the easiest calculations to make are cap rate and ROI.
Begin by using the cap rate calculation to narrow down similar properties in the same market to invest in, then use then calculate the potential ROI based on the total amount of money you have to invest.
