Cap Rate vs. ROI: What's the Difference?
Two of the most important metrics in real estate investing are often confused. Here's what each one actually measures and when to use them.
If you're evaluating investment properties, you'll hear "cap rate" and "ROI" thrown around constantly. They sound similar, both measure profitability—but they answer fundamentally different questions. Using the wrong one leads to bad decisions.
Here's the 4-minute breakdown that clarifies both.
Cap Rate: Property Performance Without Financing
Capitalization Rate (Cap Rate) measures a property's potential return based on the income it generates, completely ignoring how you paid for it.
The Formula
Net Operating Income (NOI) = Annual rental income - operating expenses (not including mortgage)
What It Tells You
Cap rate answers: "How much does this property earn relative to its price?"
It's like a stock's dividend yield—it shows the property's earning power independent of how you finance it. A 7% cap rate means the property generates 7% of its value in net income annually.
Example
- Property price: $500,000
- Annual rent: $48,000
- Operating expenses: $13,000 (property tax, insurance, maintenance, vacancy)
- Net Operating Income: $35,000
- Cap Rate: $35,000 ÷ $500,000 = 7.0%
Notice: No mortgage payment in this calculation. Cap rate is financing-neutral.
ROI: Your Actual Return on Your Actual Investment
Return on Investment (ROI) measures your personal return based on the cash you actually put in and what you get out.
The Formula
Cash Flow = NOI - Mortgage Payment
Cash Invested = Down payment + closing costs + repairs
What It Tells You
ROI answers: "How much am I making on the money I put in?"
This is your personal return. It includes your mortgage (leverage), appreciation, principal paydown, and all the cash you invested upfront.
Example (Same Property)
- Property price: $500,000
- Down payment (20%): $100,000
- Closing costs: $10,000
- Total cash invested: $110,000
- NOI: $35,000
- Mortgage payment (P&I): $24,000/year
- Cash flow: $11,000
- Principal paydown: $8,000
- Appreciation (3%): $15,000
- Total return: $34,000
- ROI: $34,000 ÷ $110,000 = 30.9%
Same property, 7% cap rate, but 30.9% ROI. Why? Leverage.
The Key Differences
When to Use Each
Use Cap Rate When:
- Comparing multiple properties on equal footing
- Evaluating market rates (e.g., "7% cap is typical for this area")
- Buying all-cash or analyzing property quality independent of financing
- Quick screening—cap rate is easier to calculate
Use ROI When:
- Evaluating your specific deal with your financing terms
- Comparing to other investments (stocks, bonds, other properties with different down payments)
- Making personal investment decisions
- Measuring actual performance after you own the property
Common Mistakes
1. Confusing Cash-on-Cash Return with ROI
Cash-on-cash return only measures cash flow ÷ cash invested. It ignores appreciation and principal paydown. ROI includes all returns.
2. Thinking Higher Cap Rate = Better Investment
Not always. A 12% cap rate in a declining neighborhood might be worse than a 5% cap rate in an appreciating market. Cap rate doesn't capture appreciation or risk.
3. Using ROI to Compare Properties
Since ROI varies based on your down payment, loan terms, and assumptions about appreciation, it's not ideal for comparing properties objectively.
The Bottom Line
- Cap Rate measures the property's earning power, independent of how you finance it
- ROI measures your total return on the cash you invested, including leverage, appreciation, and principal paydown
- Use cap rate for screening and comparing properties
- Use ROI for decision-making based on your specific situation
- Both matter—don't rely on just one
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