A lot of people who are investing in real estate often confuse CAP Rate and ROI (Return on Investment) as being the same, but they are different. The cap rate is the expected return based on the property value, but the ROI is the return on your cash investments, not the market value.Â

There are a few key differences between cap rates and ROI’s when determining an investment’s potential. The cap rate formula considers only the net operating income (NOI), which is the income that is left over after all the operating expenses have been paid, but does not consider any debt (mortgage) obligations that encumber the property. It is a good calculation to use for a quick and dirty analysis when comparing properties and what a quick look at which one may have the most potential. Â

The ROI is a little more in-depth and considers the annual cash return after the debt payments and other operating expenses. It also looks at your actual cash investment, not the current market value of the property. This is a big difference since the cap rate assumes an all-cash investment, whereas the ROI considers how much money you are putting down, transaction cost, as well as any other cash injection for renovations and repositioning of the asset. Â
Deciding whether to use cap rates vs. ROI to compare properties is a big decision. Personally, I recommend using both. The cap rate calculation assumes that there is no debt on the property, whereas ROI can be used since it only considers the amount of money you are putting down on the property, in the case of a real estate transaction, your down payment and other hard cash you are putting into it. Â
Now that you have a better understanding of the difference between CAP rate analysis and ROI, I’ll break out a formula to calculate each of them.
CAP RATE formula: Â
Cap Rate = Net Operating Income (NOI) / Current Market Value (or for the sake of analysis to determine if you are going to purchase a property, it would be what you are paying for the property.)
So, if a property is generating $100,000 in annual net income (NOI) and has a purchase price of $1,000,000, it has a cap rat rate of 10%. The equation would look like this:
$100,000 / $1,000,000 = .010 or 10%. Â Â
This is important to take with a grain of salt since you are using the seller’s provided information on expenses if you can substitute expenses that you know you will have, such as adjusted property tax values, adjusted insurance values, and your cost for management and other operating expenses that the seller may not have included.Â
Return On Investment (ROI) formula for cash transactions
ROI = Net profit / total investment
Example - You paid $100,000 in cash for a rental property. The closing costs for the property were $1,000, and you spent $9,000 remodeling the property, but you collected $1,000 in rent each month.
A year later, you have now earned $12,000 gross, but your expenses, including the utilities, taxes, and insurance, total $200 per month, or $2,400 for the year, earning you $9,600 net operating income.
The property’s ROI would look like this:
$9,600 / $110,000 = .0087 or expressed as a percentage, 8.7% Return on investment in year one. Assuming all things stayed the same on this investment for operating expenses in year two, but you didn’t have to do any renovations or closing costs, your ROI would look like this:
$9,600 / $100,000 = .096 or 9.6%.
The ROI for financed transactions is a little different. We are going to use the same example as above but apply loan leverage. So, let’s assume you took out a 30-year loan on the property with a fixed 4% interest rate. You took out a conventional loan, putting down 20%, or in this case, $20,000, borrowing $80,000.  The payments for an $80,000 mortgage for principal and interest would be $381.93 per month.Â
We will add in the same $200 per month to cover utilities, taxes, and insurance, making your total monthly outlay $581.93, and we will keep the same rental income at $1,000 per month ($12,000 for the annual term). Â Your annual return on this was $5,016.84, calculated by taking the NOI of $418.07 (which is the $1,000 - $581.93) multiplied by 12 months. Â
Now, to calculate the ROI, it’s going to be a little different. In our earlier example on this property, we paid cash for the investment, but here we are utilizing leverage, and since ROI is a return on investment that is based on our cash outlay, it will look like this.  $20,000 for the down payment, closing costs were $2,500 (since financed transactions have higher closing costs than cash transactions), and renovation work was $9,000 for a total cash outlay of $31,500.
ROI = $5,016.84 / $31,500 = 0.159 or expressed as a percentage of 15.9%.
You can see in the case of applying leverage that the return increased significantly. Â Now, taking the same example, assuming all things were the same in operations for year 2, but you do not have the closing costs or renovation loan, your ROI would look like this:
$5,016.84 / $20,000 = .2508, or expressed as a percentage, 25%, and the bonus here is we did not factor in the I.R.R. (Internal Rate of Return), which is unique to each investor because it considers tax saving implications and things like interest payments on borrowed money for investment business purposes can be considered a tax deduction against other incomes.Â