It's all about the numbers when it comes to buying an investment property. Understanding how much a property will produce in cash flow, what it's worth, and what type of return it will yield is crucial in comparing investment properties. But with so many ways to value real estate, it can be difficult to know which metric is best to use.
This article compares two of the more common investment metrics -- cap rate vs. ROI -- to help you understand how to use them, when to use them, and which is better to use when analyzing a real estate investment.
What is cap rate?
Cap rate stands for capitalization rate and is used to value commercial real estate, such as an apartment complex, industrial property, or office building. Since this metric values property based on the income it produces, it's easy to compare different investment opportunities even though they may have different features, square footage, or number of rentable units.
The cap rate calculation takes the net operating income (NOI), which is the annual net income after expenses but before debt service, and divides it by the property's purchase price.
When to use cap rate
Every sector of commercial real estate (CRE) and each unique real estate market will have a defined market cap rate at a given time. This is the average cap rate that type of CRE is seeing in the specific area and helps sellers and buyers understand market valuations.
For example, if a property owner wants to list their multifamily property and 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, the property should be listed for $1.25 million ($87,500 / 7% = property value).
When it comes to buying an investment, the cap rate can be used to determine how good of a deal an investor is getting in relation to the market. If the market dictates a 7% cap rate but the investor is able to buy the property at 11%, they're getting a higher portion of income for their investment.
A higher cap rate means the investor is achieving a higher return, but it often also means the buyer is taking more risk with the property. The cap rate also assumes the value and rate based on the full purchase price or value of the property. It doesn't take into consideration the investor's portion of the investment, which is likely far less than the total purchase price.
A capitalization rate is by far the most common metric used to value real estate and is a crucial part of evaluating a commercial property, but it's not the only metric to use.
What is ROI?
ROI stands for return on investment and is one of the easiest ways to assess an investment return. ROI is the percentage return an investment achieves on an annual basis using the net income divided by the initial investment.
For example, if a rental property produces $200 after operating costs and mortgage payment and the investor paid $18,000 to purchase the property, the cash return would be 13.3% ($200 x 12 = $2,400 annual income / $18,000 acquisition cost = 13.3% ROI).
When to use ROI
The ROI formula is not only used in residential real estate and commercial real estate but also in other investments where rental income is produced. It's an easy metric to use to look at the annual rate of return an investment produces. The higher the rate of the return, the less time it takes for your money to be returned to you (the more money your money makes). The lower the return, the longer it will take for your money to be returned to you.
Which is better to use when analyzing a property?
It's hard to say one is better than the other because they're both used to demonstrate different values in the marketplace. A cap rate is largely tied to the value of the real estate, while ROI directly relates to the investor's personal return on investment based on the money they've put into the investment property.
If a real estate investment is a value-add opportunity, where the buyer has the opportunity to improve the property through renovations, increasing rental rates, decreasing expenses, reducing vacancy rate, or improving management operations, ROI won't be a great indicator until it's producing income. Cap rate, on the other hand, would be the better indicator of the return the investor is achieving.
Conversely, if the property is performing and operating near market standards, ROI is a better metric to use because it takes into account the total investment made by the buyer as it relates to the income the property produces.
Since both calculations are fairly easy to derive, it's a good idea to use both when looking at a new investment opportunity. Knowing which metric is a better indicator for the value of an investment compared to another really comes down to the investment, how it's currently performing, and what information you're trying to compare. If you have $20,000 available to invest and you're trying to compare the return of two different investments based on the income they produce, use ROI. If you're looking at two different apartment complexes, one that's a 5% cap rate and the other that's 8%, you can easily see which is a better return for your money.