Difference between ROI and Cap Rate

[Luke Davis]

I was wondering what exactly is the difference between ROI and Cap Rate. From my understanding ROI is initial investment/net income x 100.

Is this the same for the cap rate, or is it calculated differently?

[Immanuel Sibero]

@Luke Davis

With the so many metrics thrown around on BP, some are straightforward some are not, and still others are often misunderstood (i.e. cap rate being the most misunderstood), it may help to first identify WHAT can be measured in a real estate investment and then look at HOW they are commonly measured.

The four sources of return in rental real estate (i.e. WHAT we want to measure):
1- Cash flow
2- Loan paydown
3- Appreciation in value
4- Tax savings

Some examples of metrics used to measure return (i.e. HOW we measure):
- CoC (Cash on Cash) is a measure of net return generated by TWO sources (i.e. Cash flow and Loan paydown) on an annual basis.

- Equity Multiple (or ROI) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. Equity Multiple does NOT take into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

- IRR (Internal Rate of Return) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. IRR takes into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

- Cap Rate (Capitalization Rate) is a measure of how efficient a property generates NOI in relation to the property's cost/value. The problem with cap rate is NOI does not paint a complete picture of a property return (see the "four sources of rental real estate returns" above for a complete picture), so cap rate is a poor measure of return because it does not measure any one of the above source(s) of return. Cap rate, however, is commonly used as measure of value/risk.

IMO, cap rate does NOT belong here (when talking about performance measure). I include it because it is so commonly used by investors (incorrectly, I might add). Hope this helps.

Cheers... Immanuel