Commercial real estate investors are always interested in making well-informed decisions and they use several metrics in doing that. Cap rate (capitalization rate) and ROI are some of these metrics relied on by investors to forecast the profitability of commercial real estate. So investors want to know, is cap rate the same as ROI?
Is Cap Rate the Same as ROI?
No, cap rate is not the same as ROI. Both cap rate and ROI are similar because they are used by commercial real estate investors in forecasting the potential returns from commercial properties. ROI calculates what the return on a property could be over time, while cap rate measures what the return should be or currently is.
What Is Cap Rate?
Capitalization rate, or cap rate for short, is a financial metric used in commercial real estate. It is used to calculate the potential rate of return on commercial properties, based on the property’s present or projected net operating income, and the value or price of the property.
Cap rate effectively calculates the percentage of your capital you will make back over a one-year timeframe. For example, if the cap rate on a property is 8%, you can expect to make 8% on your invested capital. This means, given the same risk profiles, higher cap rates are better than low cap rates when comparing properties.
When comparing properties using cap rates, you should only compare properties in the same asset class and same market. This is because income and property value are different across asset classes even in the same market and the cap rate of properties in the same asset class would vary from city to city.
How to Calculate Cap Rate
To calculate cap rate, you need two variables:
- The net operating income (NOI) and,
- The property value.
The net operating income is the actual or projected annual rent minus the annual property expenses (excluding mortgage costs) while the property value is an estimate of the property’s current market value or asking price.
Once you have the figures for your NOI and property value settled, you have to divide the NOI by the property value to get your cap rate. Here is the formula for calculating the cap rate of a commercial property:
Cap Rate = Net Operating Income / Property Value
What Is ROI?
Return on Investment, or ROI, is a metric that measures the percentage rate of return on commercial property over a certain timeframe, typically a year. When calculating the ROI, unlike the cap rate, you factor in debt service and the cost of purchasing the property as opposed to the property’s total value.
The ROI of a property is expressed as a positive value when the property makes a positive cash flow. If it makes a negative cash flow, the ROI will be expressed as a negative value. Typically, given similar risk profiles, having a higher ROI on a commercial property beats a low ROI in almost every case.
How to Calculate ROI
To calculate ROI, you need two variables, annual return, and total cash investment. The annual return of a commercial property is the annual revenue minus the annual expenses while the total cash investment is the down payment you made on the property. You then divide the annual return by the total cash investment.
ROI = Annual Return / Total Cash Investment
When to Use Cap Rate and ROI
The cap rate is extremely useful at two points in commercial real estate investing:
- The beginning of the transaction and,
- The end of the transaction.
In the beginning, the cap rate can be used to screen alternative investment options. In the end, you can use the cap rate to estimate the property’s “terminal value.”
After narrowing down potential commercial real estate investment options using cap rate, you can then use the ROI formula to determine the return potential returns on each of the commercial properties.
Differences Between Cap Rate and ROI
The table below summarizes the major differences between cap rate and ROI.
|Numerator||Net Operating Income||Annual Cash Return|
|Denominator||Property Value||Total Cash Investment|
The major differences between the formulas of cap rate and ROI is in the numerator and denominator. The numerator used in calculating the cap rate is NOI, a metric that does not factor in debt service metric, while for ROI, it is annual cash return, a metric that is net of mortgage payments.
For denominators, you use the property value for cap rate while you use the total cash investment for ROI. The defining factor is debt. With cap rate, there is an assumption that the property was purchased with cash, while ROI considers the impact of debt as a factor. This is why both factors are important.
Buying, selling, and managing commercial real estate can be quite demanding. There are several other financial metrics that you will need to consider. If you are in the Cincinnati MSA, Si Vales Valeo Real Estate can offer their professional services to guide you through all the steps of real estate acquisition, ownership, and disposition.
Does Cap Rate Include Mortgage Costs?
No, cap rate does not factor in mortgage costs. It only makes use of the annual income, the annual expenses (excluding mortgage), and the property value.
How Does Cap Rate Affect Value?
Cap rate does not affect the property’s value. Instead, it is the property value and net operating income that influence the cap rate of a property.
The cap rate and ROI both have their uses and importance to a commercial real estate investor. Cap rate allows you to quickly gauge the potential return on investment property, especially during the research phase, while ROI gives you a more holistic view of the deal as it considers factors like revenue streams, property expenses, and all financing costs.