What’s the Difference Between Cap Rate, ROI, and Cash-on-Cash Returns?

What's the Difference Between Cap Rate, ROI, and Cash-on-Cash Returns

A real estate investor walks into a bar.
What’s the difference between Cap Rate, ROI, and Cash-on-Cash Returns?

he asks the bartender, who responds, Doesn’t worry about it – buy a shot and a beer, and tell me about your deals! This is how most investors talk about real estate investments – but let’s figure out what those terms mean, so we can make better decisions about how to earn our income as real estate investors!

The importance of property selection

As a real estate investor, it’s important to understand the difference between cap rate, ROI, and cash on cash returns. They all measure different things and can give you different insights into a property. CAP rate is annual net operating income divided by the total cost of acquiring and rehabilitating a property (inclusive of land). It is typically expressed as a percentage. ROI is the annual net operating income from an investment divided by its purchase price or acquisition cost, usually expressed as a percentage. Cash-on-cash return measures how much profit you make after subtracting your initial investment from your return; this amount is also typically expressed as a percentage.

Understand your financing options

Before you start shopping for investment properties, it’s important to understand the different financing options available to you. Conventional loans, FHA loans, and hard money loans all have their own pros and cons. Work with a lender to figure out which option is best for your needs.

How much can you afford to invest?

When you’re trying to figure out how much you can afford to invest in a property, there are a few different things you need to take into account. First, you need to have a clear idea of your financial goals. Are you looking to make a quick profit? Or are you aiming for long-term wealth building? Once you know what your goals are, you can start to look at properties that fit within your budget.

Evaluate your cash flow expectations

When you’re looking at a potential investment property, it’s important to understand what your expected cash flow might be. There are a few different ways to measure this, including cap rate, ROI, and cash-on-cash returns. Here’s a quick guide to help you understand the difference between each one.

Amortization period

The amortization period is the length of time it will take to pay off a loan. The standard amortization period for a mortgage is 30 years, but it can be shorter or longer depending on the type of loan. For example, an FHA loan with 20% down would have an amortization period of 25 years. If you know your desired investment horizon and current interest rates, then you should plan ahead in order to determine what length of amortization period is best for you.

A property’s cap rate (or capitalization rate) is the ratio between net operating income and its purchase price.

Rental yield vs capitalization rate (cap rate)

Rental yield is a measure of how much income an investor can expect to earn from a property in a given year, while the capitalization rate (cap rate) is a measure of what an investor can expect to earn on their investment in a given year. Both are important metrics for real estate investors, but they’re not the same thing. Here’s a quick guide to help you understand the difference between rental yield and cap rate.
1. A high rental yield indicates that a property has been rented at a price that generates more income than the annual cost of owning it, so your return on investment will be greater than 100%.
2. A low cap rate indicates that there is high competition for this type of property or that it doesn’t generate enough revenue to cover its costs, so your return on investment will be less than 100%.
3. There is no right answer when it comes to comparing these two metrics: both offer valuable insights into how a property performs.
4. To figure out which metric matters most, think about your situation: if you plan to hold onto the property for several years and want cash flow now, then the rental yield would be the better measure of success; if you want to grow your portfolio as quickly as possible with minimal cash down payments, then focus on cap rates.

Return on investment (ROI)

The return on investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.

Cash-on-cash return

A cash-on-cash return is a real estate investment performance metric that measures the rate of return on an investment property based on the cash that is invested in it. To calculate it, you divide the net operating income (NOI) by the total cash invested.

For example, let’s say you buy a property for $100,000 and put $20,000 down. The property generates $2,000 in monthly rent and has $200 in monthly expenses.