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Cap Rate vs ROI: What's the Difference?

Jerry Norton

Aug 8, 2024

aerial photography of rural

Because your real estate investing business will depend upon your ability to understand the language of the industry — including key vocabulary terms — I wanted to take a moment to explain two important terms that I've seen many investors — beginner and experienced alike — confuse: cap rate and ROI.

So, what are they, what's the difference between the two, and how will each one affect your real estate business?

Let's get started!

Defining Cap Rate and ROI

What is Cap Rate?

The cap rate, short for capitalization rate, is used to determine the potential return on a real estate investment based on the property's income.

It's calculated by dividing the net operating income (NOI) of the property by its current market value.

The resulting percentage represents the annual return you can expect to receive from the property, assuming it is purchased entirely with cash and without considering mortgage financing.

Why is cap rate so important for you as a real estate investor? Well, cap rate is a quick way to evaluate the profitability and risk associated with a real estate investment.

A higher cap rate indicates a higher potential return but may also a riskier investment, while a lower cap rate suggests a more stable investment but potentially lower returns.

What is ROI?

On the other and, ROI, or return on investment, is a broader and more of a "full picture" metric that considers the overall profitability of an investment property, taking into account the amount of capital invested, any income earned, and any expenses incurred.

Make sense?

Key Differences Between Cap Rate and ROI

So, what are the biggest differences between cap rate and ROI?

One key difference between cap rate and ROI lies in their calculations.

What do I mean by this?

Well, cap rate is derived from the property's net operating income divided by its market value, while ROI takes into account the full investment cost and net profit.

Cap rate focuses solely on the income aspect, whereas ROI provides a more comprehensive view of the overall financial impact of the investment.

Another difference is the way these real estate investing metrics evaluate risk and profitability. Cap rate looks at the potential income stream generated by the property.

A higher cap rate implies higher income relative to the property's value. What does that mean? Higher risk but also higher returns.

On the other hand, ROI considers both the income and the investment cost, giving valuable insight into the profitability of the investment as a whole.

While a high cap rate may seem good, it doesn't guarantee a high ROI if the investment costs are significant, something I've learned myself.

ROI provides a more "holistic" view of the investment by factoring in all costs associated with acquiring and maintaining the property, including expenses such as property taxes, insurance, maintenance costs, and potential vacancies.

When to Use Cap Rate or ROI

At what point should you as a real estate investor use cap rate, and when should you use ROI? Keep reading to find out?

Cap Rate

Cap rate is useful when comparing similar properties in the same market or when evaluating income-generating properties, such as rental units.

Why is this the case?

It's simple: Cap rate focuses on the income aspect and provides a straightforward way to assess a property's potential for generating income relative to how much it costs.

ROI

ROI, on the other hand, should be used when making investment decisions that require considering the entire financial impact of the investment. It provides a more comprehensive analysis by accounting for the investment cost and ongoing expenses.

If you're thinking about expected cash flow, financing options, and long-term profitability, you'll want to use ROI.

The Bottom Line: Cap Rate vs ROI

There you have it: Cap rate and ROI. They are two powerful metrics and terms that can help your real estate business, whether you are fixing and flipping, landlording, or even wholesaling.