Can someone please explain the difference between Cap Rate and ROI? Also, why is cap rate = Yield(discount rate) - Growth

lmaondfef's picture
Rank: Chimp | 8

I thought the cap rate was the expected return of an investment which you get by dividing stabilized net income/value. Like I get that it is a ratio relating first year income to value and a dictation of how capitalized income is influencing prices. I am confused as there are many resources that say that cap rate and ROI are totally different yet some say they are the same.

Comments (11)

May 22, 2020

Cap Rate = NOI / Value of the Property
ROI = EBIT / Invested Capital

invested Capital is how the Company/property is capitalized (equity + NIBD)

So cap rate is an unlevered figure and ROI is levered

NOI almost equals EBITDA, so see the cap rate as a multiple (imagine its 4%, so you could multiple NOI with 20 to get the same result as dividing by 4%)

Hope it answered your question

  • Intern in IB-M&A
May 23, 2020

If it's 4%, shouldn't it be the same thing as multiply by 25 instead of 20?

May 23, 2020

obviously correct ;-)

May 22, 2020

ROI is fairly misleading term, "return on investment" as the return is usually meant as annual, and not a total return. If it is meant as total return, it's not time valued. As such, it is a term I've only really seen in pop-real estate books and never in any institutional context.

True real estate people will measure equity yield (closest thing to ROI) aka cash-on-cash return, IRR, NPV, equity multiple. ROI just has no meaning to the finance world, so not really used in practice.

To note, cap rate is a valuation metric, it is the same as the PE ratio for stocks (in fact its just the mathematical inverse). Cap rate should never be thought of as return metric.

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May 22, 2020

Also, Cap Rate = Discount Rate - Growth, is just well because it is.

The formula for a growing perpetuity is CF1/(R-g), so in real estate we are just too lazy (or really don't know or don't want to break out the two) to break them out. Cap rate is faster and easier to talk about. Like I said above, it's just a valuation multiplier, so it works by the convention it has.

May 22, 2020

Not to be nitpicky, but the cap rate = DR/IRR - Growth only applies if you hold exit cap and growth constant (or at least smoothed).

I.e., if you have a market where rent growth projections (or actual measured rental rate changes) =/= contractual income growth (per lease(s)), this may not be 1-1. Similarly, let's say you have an exit cap that is 50 bps in either direction, then this could be different.

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Most Helpful
May 22, 2020

The cap rate formula makes no assumptions about holding period, and assumptions of true discount rate and expected growth are implicit (I mean, make an assumption and make explicit if you so choose). So I don't know how or where exit cap expectation fits into the cap rate formula. It's just Value=Income/Rate. The rate if market based and income is one year forward NOI.

You could hold to infinity, wouldn't change.

You are correct, in that all else equal, a property with expected NOI growth should have a lower cap rate (holding risk constant) than one with flat rents. In short, that all goes to explaining why a certain cap rate is 'low' vs. 'high' relatively.

Again, if you think of cap rates like Price/Earnings multiples from stocks, the definition of cap rates is way clearer. We know 'growth' stocks have higher PEs relative to 'value' stocks, same game in RE. Just the relative risk perception tends to overpower growth expectations in many cases.

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May 23, 2020