The Difference Between Cap Rate and Return on Investment (ROI) and its importance for Investors

by

The commercial real estate industry is growing significantly. As a result, there are now a lot of opportunities for investors to choose from and get a good return. But when you are a new investor in the industry, there are a lot of aspects you need to know about.

The two most useful financial metrics which investors widely use for forecasting the potential return on the rental property include ROI and cap rate. It is an excellent means to understand if the property is suitable for investment and how you can benefit from it.

Once you are satisfied with all the essentials and know that the property will bring a good return, you can look for commercial real estate loans and invest in the property. Undoubtedly, real estate investments are pretty beneficial, but they will only when you put your money in the right place. So the guide here will explain the essential attributes that will allow you to analyze the property to the very best and make the right decisions.

What is the cap rate?

Capitalization rate is the most vital financial metric that real estate investors use to calculate the rate of return expected from the investment. The result of the same is based entirely on the property’s net operating income in the current time or as what it will produce and the property value or its price.

It would help if you only did the calculation for comparing the similar properties present in the same submarket or market for two main reasons. Firstly, property price and income can vary significantly between asset classes like residential rental and office buildings. Further, the cap rate can differ from one city to another for the same property type due to demand and supply, the number of people walking from home, and real estate prices.

Irrespective of the difficulty or challenges, when there is a need to fund a project, you can look for commercial real estate bridge loan lenders to get them the necessary funding. Remember, they will also check the possible return from the property before providing the required amount to safeguard their money.

For instance, the cap rate of the residential property in the San Francisco bay area can be a lot lower than that in Nashville. This is because the housing price can be extremely high in California.

Calculating cap rate

To help understand the calculation of cap rate, here is an example. Let’s assume that you are looking for a rental property with an annual rental income of about $18000 per year.

Considering the 50% rule, you can anticipate that the regular operating expenses can be half of the gross annual income. Therefore, the NOI you can expect can be about $9000 per year.

If the property has got a price of about $120000, then the projected cab rate will come to around 7.5%. The formula used here for the calculation is Cap rate=NOI/Property Value.

What does a higher cap rate mean?

When you compare two similar properties in the same market for investing in the property, the one with the highest cap rate will be a better investment. This is because it has a better chance of bringing in a higher return or something equal. However, if you find a property that has gained a cap rate that is much higher than the steady market cap rate, then it can be a red flag.

If you see a home is rented for above-market rent, then the cap rate will typically be high because the NOI here is higher. But if the current tenant does not go ahead to renew the lease because the rent is too high, then you will have to lower the rent for the new tenant. Thus the cap rate will become lower.

Further, your recently purchased property value can decrease because your NOI has significantly reduced.

What is ROI?

The investment rate is the percentage of return that the investment can bring over a specified period. In contrast to the cap rate calculation or ROI, here include the amount of money you have used for purchasing the property and the debt service.

The rate of return can significantly impact your payment for the commercial real estate loans, so it is vital to pay extra attention to this aspect so that you don’t end up with the wrong investment that can lead to great trouble.

Calculation of ROI

To better understand ROI, here is an example that will help you. It would help if you assumed about purchasing a property with an asking price of about $120000, which generates NOI before any debt service of about $9000.

If you choose the conservative down payment method of about 25%, then the investment will be $30000, and the annual return can be $4420 after the commercial mortgage payment. With the information, it is clear that the ROI that you can expect from your investment can be about 14.73%.

The formula used for the calculation is ROI= Annual Return/Total Investment.

What higher ROI means?

If you choose to put $30000 in a rental property, then the ROI of the property will generally be the best investment. But, of course, you still need to ensure that the current rent is at the market rate and the property expenses won’t increase after you have purchased due to the items like deferred maintenance.

You can increase your ROI by making use of different amounts of leverage. For instance, the ROI on the same $120000 property can be based on the down payment like 15%, 25%, or 10%.

The investor needs to pay extra tension to the ROI and the lower down payment as it is pretty essential, even though the annual return on the cash is invested in being low.

A good idea is not to use too much leverage when investing in rental property. This is because the loan to value on the investment property can be too high.

Thus you will have trouble getting a commercial real estate loan at a reasonable interest rate. Also, there is a possibility of negative cash flow if there are unexpected repairs or if it requires extra time to find a new tenant for leasing the property.

Choosing the best

There is no such rule that you need to decide between ROI or the cap rate. The most successful investors use both financial metrics to select the right property to invest in. As the calculation for both metrics is relatively easy, one can quickly identify what property will bring a good return.

The cap rate will specify what return from income property is or what it should be. In contrast, the ROI clearly sets the return on investment you can expect over a while.

When comparing two investment properties, the one that comes with a higher cap rate will be a better option for you. On the other hand, if you have allocated a specified amount of money for an investment, you can use the ROI calculation to see if the property will bring in more income based on your initial investment.

Thus it is vital to start researching to identify which property will be helpful for you to get the expected return and good benefits. No doubt, research can be pretty beneficial. It is the key to getting good returns on the property.

You must understand that multifamily assets generally have low cap rates with the market because they provide lower returns than the other options.

Therefore, when analyzing a potential investment, you need to determine the correct cap rate. You can consider multiple other factors like type, location, and the current interest rate to acknowledge the benefit you can get with the investment.

With the correct cap rate or ROI, you quickly analyze all the risks associated with the deal. Real estate investments can be pretty complicated, but the benefits will be worth it.

This is why it is vital to have proper understanding and knowledge before investing. When you research correctly and put the money in the right place, the rate of return can be pretty high, making the deal worth it.

Also, you must get in touch with good commercial real estate bridge loan lenders to understand the interest rate and get the required funding for the project you are planning to invest in.

Conclusion

When starting as a real estate investor in the industry, different financial metrics and concepts are used for valuing property. No doubt it can be confusing at first but understanding it correctly is the key to avoiding complications and succeeding in the long run.

If you think it is not very easy to understand, you can consider taking professional help. Private Capital Investors is the one you can rely on. They have an experienced professional who will help and guide them in the right direction. With their professional assistance, you will better invest in the right place and get good benefits.

Want to learn more? Get in touch with us today.

Similar Blog

What is BRRRR? Is this Framework Right for You?

What is BRRRR? Is this Framework Right for You?

Real estate investment has become quite broad. As a result, there are different strategies that people can make use of to improve their earning resources and reduce the risk associated with the process. The strategy works well for experienced and fresher investors to...

Is Commercial Line of Credit Right for Your CRE Projects?

Is Commercial Line of Credit Right for Your CRE Projects?

Real estate investment requires a considerable amount of funding. However, in most cases, the investors lack funds in hand. Thus they look for financing options that will help them to ease the experience and make the investment. One such strategy is a line of credit....

How Your Rental Property can Make Money?

How Your Rental Property can Make Money?

The rental property investment is attractive as it assures a fixed income for years. The rental property investors in the US enjoy the benefit of 30 year fixed mortgage rate. This type of mortgage is very much an outliner compared to the country's other options. Most...

Want to learn more? Get in touch with us today.

Our experienced team is ready to assist with your financing needs.

Address:
2101 Cedar Springs Road Suite 1050 Dallas, TX 75201

Phone:
(972) 865-6205

Email:
info@privatecapitalinvestors.com