**Cap Rate** and **ROI **are two of the most useful financial metrics real estate investors use to forecast the potential return from rental property. One calculation measures what the return could be, while the other calculates what the return is or should be.

Let us further discuss these two important metrics.

**Capitalization rate – or cap rate **– is a financial metric used by investors to calculate what the rate of return from an investment is based on the net operating income the property currently or should produce and the property value or price. Debt such as a mortgage payment is excluded from the cap rate calculation to make an exact comparison because some investors will use more leverage than others, and vice versa.

The cap rate formula is

- Cap Rate = Net operating Income / Property Value

**For example, **assume you’re looking at a rental property with a gross annual rental income of $18,000 per year. Based on the 50% Rule, you anticipate that your normal operating expenses (excluding the mortgage payment) will be half of your gross annual income. That means your NOI will be $9,000 per year.

If the property has an asking price of $120,000 your projected cap rate will be 7.5%:

- NOI / Property Price = Cap Rate
- $9,000 NOI / $120,000 Property Price = 0.075 or 7.5%

The cap rate calculation should only be used to compare similar properties in the same market or submarket because income and property prices vary between asset classes – such as residential rental property versus office buildings. Cap rates also are different from city to city for the same property type, due to factors such as supply and demand, people working from home instead of commuting into the office, and real estate prices in general. For example, the cap rate from a residential rental property in the San Francisco Bay Area might be much lower than the cap rate from a house in Nashville, because housing prices are extremely high in California versus a lower cost of living area like Tennessee.

When comparing two more similar properties in the same market to invest in, the property with the highest cap rate will be the better investment because your potential return is higher, everything else being equal.

**ROI – or return on investment **– tells you what the percentage return on an investment could be over a certain period of time. Unlike the cap rate calculation, the ROI formula includes debt service and the amount of money you used to purchase the property instead of the entire property value.

The ROI formula divides the annual cash your rental property is generating after operating expenses and the mortgage payment by the total amount of money you invested:

- ROI = Annual Return / Total Investment

Once you’ve narrowed down alternative investment options using the cap rate formula, you can use the ROI formula to calculate what your return could be for each property.

For example, assume you’re thinking about buying a property with an asking price of $120,000 that generates an NOI (before debt service) of $9,000.

If you use a conservative down payment of 25%, your total investment would be $30,000 and your annual return would be $4,420 after factoring in the mortgage payment (P&I). Based on this information, your ROI would be 14.73%:

- ROI = Annual Return / Total Investment
- $4,420 Annual Return / $30,000 Total Investment = 0.1473 or 14.73%

If you’ve allocated $30,000 to invest in a rental property, then the property with the ROI will generally be the best investment. Of course, you’ll still need to make sure the current rent is at market and that the property operating expenses won’t increase after you purchase the property, due to items such as deferred maintenance.

You can also increase your ROI by using different amounts of leverage. Here’s what the ROI on the same $120,000 property would look like based on a down payment of 25%, 15%, and 10%:

Down Payment Total Investment Annual Return ROI

25% $30,000 $4,420 14.73%

15% $18,000 $3,804 21.13%

10% $12,000 $3,504 29.2%

For an investor focused on maximizing ROI, the lower the down payment is the better, even though the annual return on the cash invested is lower. However, it’s a good idea not to use too much leverage when investing in a rental property.

That’s because if your loan-to-value (LTV) on an investment property is too high, you’ll have trouble getting a loan at a good interest rate. Also, you could have negative cash flow if there are unexpected repairs or it takes longer than expected to find a new tenant to rent the home.

**Is Cap Rate same as ROI?**

The answer is no, Cap rate tells you what the return from an income property currently is or should be, while ROI tells you what the return on investment could be over a certain period of time. Both calculations are easy to do and can help in making investment decisions. you may use the cap rate calculation to narrow down similar properties in the same market to invest in, and then calculate the potential ROI based on the total amount of money you have to invest. Both financial metrics are used by successful real estate investors to select the best property to invest in. If you’re considering two potential investments, the one with the higher cap rate could be the better choice. On the other hand, if you’ve allocated a certain amount of money for an investment, you can use the ROI calculation to see which property will produce more income based on your initial investment.