The Difference Between ROI and Cap Rate: Explained
There are several evaluation tools that are extremely useful in determining how much bang you are really getting for your buck in real estate. CAP Rate and ROI are some of the frequently used metrics when evaluating a real estate investment opportunity.
These terms are often misunderstood and sometimes incorrectly used by some investors as well as my fellow brokers in the market. Often, while putting together a commercial property deal, I will inevitably hear some of them incorrectly or interchangeably use the terms.
Well, needless to say, this presents an opportunity to address and hopefully clear up these misconceptions (and remember, obscurity is not good in my line of business).
Most importantly, for brokers, not knowing the difference between the two could lead to a catastrophic misrepresentation of a property’s financials. We all know how that ends.
So let’s dive right into it:
The Capitalization Rate (Cap Rate) is the Net Operating Income (NOI) of the property divided by the Price (or current market value). It measures profitability and tells you how much you’d make on an investment if you paid all cash for it.
Cap Rate (%) = Net Operating Income ÷ Property Value)
The beauty of using cap rates to compare properties is that an investor can easily distinguish how the risk and reward profile of one property compares with those of other similar investments. I’ll elaborate further on other instruments such as NOI, Cash flow, Debt Coverage Ratio and building classifications in my next blog.
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The Return On Investment (ROI) also known as your Cash on Cash Return is something entirely different. It is your annual cash flow divided by equity. It measures the annual return on the initial capital you invested. The initial investment would include a down payment, closing cost, initial improvements and any other initial out of pocket cost associated with the property purchase.
ROI = Annual Cash Flow ÷ Equity
*Remember that your cash flow is your Net Operating Income (NOI) minus your mortgage payments (mortgage payment includes your principal/debt repayment and the interest)
Another way to look at it: ROI is the velocity of money; How fast my money is moving, how fast can I get back my initial investment back in my pocket.
Here are some examples:
(Now I will point out before somebody else does, I’ve ignored acquisition costs, broker commissions, potential vacancies, repairs etc. in the examples below)
ROI (Cash on cash) Example
Proper Value: AED 1,800,000
Down Payment: AED 450,000 ( 25%)
Rent – AED 150,000
Maintenance – AED 20,000
Net Operating Income: AED 130,000
Debt - 4%
LTV - AED 1,350,000 ( 75%)
Monthly Mortgage Payments: AED 7,597 pm ( @ 4% over 25 yrs)
Total - AED 91, 152 per year
Cash Flow: AED 38,848
ROI = annual cash flow ÷ down payment
8.6%= 38,848 ÷ 450,000
Note*: This is a snapshot of year one and does not take into account the potential increase in rental income and maintenance cost over the investment period, as well as interest on the reducing balance.
Cap Rate Example (Using the same figures as above)
Cap Rate = Net Operating Income ÷ Market Value
7.2% = 130,000÷ 1,800,000
So in this example, your ROI is 8.6% and your Cap Rate is 7.2%.
I never understood why “ROI” is the prevailing metric used in our local market. We should be seeing a Cap Rate of a property advertised rather than an ROI for two reasons:
1. When an income generating property is listed for sale, it is when the Cap Rates really matters - when evaluating the true profitability without taking into account how the property will be bought. It is a method of showing us the (supposed) property’s worth in comparison with the income that it generates.
2. Assuming a financed property, ROI can vary per buyer because it is dependent on the financing terms used to buy the property. So one person’s ROI might be different from another person’s ROI for the same property.
Although they are unlikely to vary that much due to interest rates, it is more likely to vary depending on how big of a down payment a buyer puts down.
Essentially, it will differ depending on what the monthly mortgage expense is which differs depending on the buyer’s qualifications, the interest rate, and the down payment.
It’s important to keep in mind that a Cap Rate is still a useful metric to evaluate the investment even when debt will be used. The ROI measures how good the deal is and how good the financing is, whereas the Cap Rate will measure ONLY how good the deal is. So you might look at ROI and think it is low but that might be due to financing rather than the property itself.
So in short, the ROI has more to do with the investor and how it affects him/her, whereas the Cap Rate has more to do with the investment itself and how it’s performing.
My next blog is on the 7 commonly used Commercial Real Estate terms, stay tuned!
Connect with me on LinkedIn:
https://www.linkedin.com/in/tshepo-samuel-maubane-20a57056
Tshepo Samuel Maubane
Director - Commercial Real Estate Advisory
famproperties.com
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