One of the challenging aspects for real estate investors is evaluating the feasibility of real estate investments. Most beginners will have come across two confusing terms, ROI and Cap Rate. In this article, we explore the meaning of the terms and how to evaluate property investments.
ROI in Real Estate
ROI (Return On Investment) measures the proportion of returns to the investment costs. You can calculate ROI from the annual cash generated per month minus operating expenses. The result is divided by the total investment.
The ROI Formula Used is:
ROI (Return On Investment) = Annual Cash Returns / Total Investment
For example, a rental generates $300 per month, and it costs 20,000 to purchase the property. The annual income would be 12 X 300 = 3,600. Therefore, the ROI would be 3,600/20,000 multiplied by 100, which is 18%.
A good ROI will depend on the type and location of the property, amongst other factors. Generally, the higher the number, the better the cash flow. Rates can vary from 6% to over 20%. But 15% is considered an ideal rate for real estate investments.
Understanding the Cap Rate
The Cap Rate is also in percentages, and it is a proportion of Net Operating Income to the property’s purchase price. It assumes all property purchases are always in cash. As such, it does not include mortgage payments.
The Cap Rate Formula is:
Cap Rate = Net Operating Income/ purchase price
The Net Operating Income is the gross income minus the operating expenses. If the NOI is 5,000 and the purchase price is $75,000, the Cap Rate would be 0.067 or 6.7%.
The Cap Rate is used to analyze similar properties in the same area. Investors can also derive the purchase price from the Cap Rate formula to gauge the viability of a rental property. The market value is Net Operating Income divided by the Cap Rate.
The Difference Between ROI VS Cap Rate
You can use both the ROI and Cap Rate to analyze real estate investments. ROI indicates the returns you can expect from your total investment in the property. The formula factors capital expenses and mortgage payments.
Cap Rate is meant for real estate investments expected to generate an income. Therefore, you can’t use it for fix-and-flip investments. The metric excludes capital expenses and mortgage debts. It makes it easier to compare returns from similar properties.
Should I Use ROI or Cap Rate?
The Cap Rate is a “useful formula used to calculate the current or potential annual rate of return”, DealMachine affirms. For ROI vs Cap Rate, the latter is ideal for gauging the viability of your existing income-generating investments.
ROI is a better metric for determining the value of an investment in the long term. You can also use ROI to compare properties of two different locations or properties.
Both ROI and Cap Rate are easy to calculate and are useful for evaluating real estate investments. The metric you use will depend on the property type, performance, and other factors. Remember, due diligence is critical when investing in real estate.