The terms return on investment and capitalization rate get thrown around a lot in fancy-shmancy real estate circles. We’re going to demystify them.
Return on Investment (ROI) is a performance measure used to measure the efficiency of an investment. In other words;
How much money is this house making me?
It is used in many forms of business, but we will focus on how it applies to real estate.
ROI measures the return on an investment compared to the investment’s cost. To calculate this, the return on an investment is divided by its cost. The result is expressed as a percentage.
For real estate, it’s the income from a property minus costs.
There are many things to keep in mind when you see an ROI from a property, such as whether you are paying cash or financing, will you include closing costs, interest, and loan paydown. The ROI can look higher than it is when certain costs are being ignored.
When you see someone bragging about their ROI, take it with a grain of salt. They may not be accounting for all their costs.
Today, we are going to focus on a specific type or measure of ROI called a capitalization rate.
Capitalization Rate (Cap Rate)
If you are calculating the ROI on a real estate deal as if it was being done in cash, you are calculating the capitalization rate, often abbreviated as cap rate.
The reason cap rate is one of the most popular measures used in real estate is it allows you to compare investment opportunities to each other.
Sometimes ROI’s are calculated by using the down payment as part of the formula. This means the ROI can change based on the size of the down payment. This isn’t the case with cap rates. The formula for a cap rate has nothing to do with down payments or mortgages.