Should I Use Cap Rate or ROI?

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Should I Use Cap Rate or ROI?

Julie Silvestro
Peoria, AZ · Member since 2017 · 27 posts · 6 votes

Hi All,

I would like to play a game inside of the Bigger Pockets forum; nowhere else can I get the opinion of so many valuable industry professionals. The game is what do y'all think is a better word for my marketing purposes? Cap Rate or ROI?

In order to answer that you will need some context:

I am working on some content for a marketing piece, i.e post cards via snail mail. I can't decide if using Cap Rate vs. ROI in the messaging is witty or will disconnect us from our readers.

The post card will be going out to Apartment Owners and I want to illicit the best response possible. What a better way to get real data before we launch then to ask the community!

We are claiming our services can provide up to 60% Cap rate/ROI in most cases. I understand that Cap Rate is basically {Net Operating Income/Property Price} vs ROI is {Net Profit/Cost of investment}.

I feel that since it's not an actual Real Estate Investment but rather a supplement to real estate in terms of NOI, that it may sound weird to use it in this respect.

On the other hand I want to connect to the apartment owners with language they actually use; the problem with ROI is mainly I feel it has less of an industry flare and will not resonate.

There is much more to the post card than the following but this is where we are stuck. Please review the two sentence choices, vote on one and share your rationale.

1) Introducing a Revenue Generating Internet System - You Own it - We Operate it. ROI as high as 60%

2) Introducing a Revenue Generating Internet System - You Own it - We Operate it. Cap Rates as high as 60%.

Also, does anyone have a good reason why I should not use Cap Rate in this context?

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David Faulkner
Investor · Orange County, CA · Member since 2015 · 2k+ posts · 3k+ votes
9y

Definitely ROI ... saying that your service raises the CAP rate demonstrates that you either don't understand CAP rate or are trying to fool those that don't understand, and neither is good. Short of physically picking up a 10 unit apartment complex and moving it to another market, you can NOT change the CAP rate ... if you improve the NOI of a commercial property (5+ units), then you do NOT increase the CAP rate (which is set by the market), you instead increase the value of the property (Value = NOI/CAP). If you are trying to apply CAP rate to SFRs or under 5 unit buildings, and then saying your service will increase CAP, then you are using the term wrong twice.

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  • Kenneth Reimer
    Rental Property Investor · Sacramento, CA · Member since 2016 · 267 posts · 214 votes
    9y

    @Julie Silvestro Hi Julie, I'm not quite sure what your business plan is, but if I received a letter that said cap rates as high as 60%, I would simply throw it away. What exactly does your business do? Achieving 10 times the capitalized return sounds way too good to be true, and doesn't sound like it has been adjusted for risk.

    2Reply
  • Patrick LiskaPro Member
    Investor · Verona, NJ · Member since 2014 · 1k+ posts · 832 votes
    9y

    Read up on CAP rate before you put that on your cards, CAP rate is an indication of the market in a general area and is mostly used in commercial properties. a 60% CAP is unheard of and if it was it means it is extremely risky, a lower CAP means a steadier return on investment and less risk. and even a ROI of 60% seems too good to be true. are you guaranteeing a return to the investor ? so if i pay you $20 for your service are you saying you will guarantee that i will get back $32 ?

    1Reply
  • Julie Silvestro
    OP
    Peoria, AZ · Member since 2017 · 27 posts · 6 votes
    9y

    Kenneth,

    Thank you for your reply, if you would throw it away I fear others would also. I feel we do have a service that is to good to be true, the trick is conveying that without looking like spam, or seeming unreal.  Soon every property owner will want to make this type of easy ancillary income, it's just not the trend yet because folks don't know what's actually possible. 

    To answer your question on what we do, we have released one of the first revenue generating internet systems of its kind. You can now own our proprietary internet delivery system, allowing apartment owners to profit from the Internet services that their residents are already consuming. You own it, we manage it. 

    Basically we have given the apartment owner the ability to become a small Internet company without the worry. Why not own it if they have access to small cities worth of residents? 

    Do you think their is a better way of saying  "you can make $30 a door in profit if your willing to pay $20 in overhead (i.e our service fees)"? Perhaps cap rate is being used in the wrong context, that's what I am trying to get to the bottom of. 

    Julie 

    0Reply
  • Julie Silvestro
    OP
    Peoria, AZ · Member since 2017 · 27 posts · 6 votes
    9y
    Originally posted by @Patrick Liska:

    Read up on CAP rate before you put that on your cards, CAP rate is an indication of the market in a general area and is mostly used in commercial properties. a 60% CAP is unheard of and if it was it means it is extremely risky, a lower CAP means a steadier return on investment and less risk. and even a ROI of 60% seems too good to be true. are you guaranteeing a return to the investor ? so if i pay you $20 for your service are you saying you will guarantee that i will get back $32 ?

     Patrick,

    I agree with you that it is common that the higher the return the higher the risk. That's not this. In my opinion that usually applies in the "Investor mind set". There are many people that are getting HUGE returns in life and it's all low risk. I mean that's the point of entrepreneurship to have huge returns. Of course I would never just give someone a 60% return if I could get it myself. The relationship of our services is that both the business owner (us) and the apartment owner NEED each other to achieve these types of returns. In fact its more like a partnership in that regard.   

    As to a your question of guaranteed returns, the short answer is yes (actually its SRP is $50) BUT there is a caveat to that answer. You see if we sell our Internet service to the owner for let say $20 per unit and they would have to actually include it in the rent or add it to the RUB's for $50 to make that return (150% annual return). Further, if we include the cost of the sytem, not just the NOI then we would have closer to a 65% Return on investment (est. $10 per unit in cost).

    I have no doubt this is a gold mine for both our business and apartment owners, my only question is how to SPEAK in a way that apartment owners will hear the opportunity?

    As Kenneth said, this sounds "to good to be true", is that out problem? 

    0Reply
  • Eric Fegan
    Commercial Real Estate Broker · Ft Mitchell, KY · Member since 2016 · 21 posts · 6 votes
    9y

    This looks like a good opportunity for some nerdy appraisal input.  

    Cap Rate is short for Capitalization Rate which can be many different types of rates.  The most common Cap Rate would be the overall capitalization rate that ignores debt or equity and only calculates the return for the overall property.  This is the rate that would typically be quoted by brokers.

    NOI/Property Value= Overall Capitalization Rate

    The cap rate is an rate of return for ONE period in time.

    ROI- Return on Investment is geared toward IRR- Internal Rate of Return of dollars invested. Again this can be the overall IRR, equity, debt, land, building, etc. Most investors are concerned about the IRR of equity. This is a multi period calculation that makes assumptions for LTV, loan costs, purchase costs, expense and income projections over time, the holding period of the investment, sale price of the investment at the end of the holding period, depreciation rates, and future tax rates

    ROI or IRR is a multi period calculation full of assumptions but allows you to estimate your potential return on equity or equity IRR before making the investment.

    IRR should be higher than Cap Rate due to positive leverage and the tax benefits of real esate.

    I hope this helps.

    0Reply
  • Patrick LiskaPro Member
    Investor · Verona, NJ · Member since 2014 · 1k+ posts · 832 votes
    9y

    Sounds to me like you are going after the self managed property owner and possibly be offering to handle the billing , collecting and paying aspect of property management so that they do not need to handle it, Just Guessing. If your an apartment owner the numbers to handle all that work should be already accounted for and to just turn around and start raising rents by $50 ( month / year ?) to cover a service may not be easy and depending on the rent, if its $50 / month  SRP  than the rent would have to be above $500 / month to make that worth while. Most PM companies charge 10% and i would rather pay $50 on a $500 rent and get full service than pay $50 on $500 rent and just get billing and paying service, if that's the business model you are going for. If that's the case, try to present it as, there time is money ( put a value to it) and that using your service will free up their time and guarantee that they will make money based on that.

    0Reply
  • Julie Silvestro
    OP
    Peoria, AZ · Member since 2017 · 27 posts · 6 votes
    9y
    Originally posted by @Patrick Liska:

    Sounds to me like you are going after the self managed property owner and possibly be offering to handle the billing , collecting and paying aspect of property management so that they do not need to handle it, Just Guessing. If your an apartment owner the numbers to handle all that work should be already accounted for and to just turn around and start raising rents by $50 ( month / year ?) to cover a service may not be easy and depending on the rent, if its $50 / month  SRP  than the rent would have to be above $500 / month to make that worth while. Most PM companies charge 10% and i would rather pay $50 on a $500 rent and get full service than pay $50 on $500 rent and just get billing and paying service, if that's the business model you are going for. If that's the case, try to present it as, there time is money ( put a value to it) and that using your service will free up their time and guarantee that they will make money based on that.

     Patrick,

    We are selling Internet that apartment owners can profit from. Its a add on. We are not trying to collect rents nor are we a  management company. I'm sorry for the confusion.

    0Reply
  • Julie Silvestro
    OP
    Peoria, AZ · Member since 2017 · 27 posts · 6 votes
    9y
    Originally posted by @Eric Fegan:

    This looks like a good opportunity for some nerdy appraisal input.  

    Cap Rate is short for Capitalization Rate which can be many different types of rates.  The most common Cap Rate would be the overall capitalization rate that ignores debt or equity and only calculates the return for the overall property.  This is the rate that would typically be quoted by brokers.

    NOI/Property Value= Overall Capitalization Rate

    The cap rate is an rate of return for ONE period in time.

    ROI- Return on Investment is geared toward IRR- Internal Rate of Return of dollars invested. Again this can be the overall IRR, equity, debt, land, building, etc. Most investors are concerned about the IRR of equity. This is a multi period calculation that makes assumptions for LTV, loan costs, purchase costs, expense and income projections over time, the holding period of the investment, sale price of the investment at the end of the holding period, depreciation rates, and future tax rates

    ROI or IRR is a multi period calculation full of assumptions but allows you to estimate your potential return on equity or equity IRR before making the investment.

    IRR should be higher than Cap Rate due to positive leverage and the tax benefits of real esate.

    I hope this helps.

     Mr Fegan,

    This was helpful, thank you. My question still looms, what will market better Cap rate or ROI for an ancillary service? Are you suggesting to use IRR in our marketing ? Perhaps a better/cleaner metric?

    0Reply
  • Cooper Bert
    Harrisburg, PA · Member since 2015 · 43 posts · 52 votes
    9y

    Good points raised above so I won't get into the technicals or make a judgement on your biz plan.

    Here is my "feel" for the words used in marketing:

    "Cap Rate" is associated with commercial investment, not so much apartments.

    "ROI" is more widely understood but still a financial terms that has "alternative" meanings.

    "IRR" is totally in the weeds and will confuse everyone.

    How about a simple "60% Return" for marketing purposes.

    Sometimes the simple way is the best way to get the message across.

    1Reply
  • Bruce Petersen
    Rental Property Investor · Austin, TX · Member since 2017 · 254 posts · 265 votes
    9y

    This feels or sounds like an MLM pitch someone hit me with couple years ago?

    0Reply
  • Julie Silvestro
    OP
    Peoria, AZ · Member since 2017 · 27 posts · 6 votes
    9y
    Originally posted by @Cooper Bert:

    Good points raised above so I won't get into the technicals or make a judgement on your biz plan.

    Here is my "feel" for the words used in marketing:

    "Cap Rate" is associated with commercial investment, not so much apartments.

    "ROI" is more widely understood but still a financial terms that has "alternative" meanings.

    "IRR" is totally in the weeds and will confuse everyone.

    How about a simple "60% Return" for marketing purposes.

    Sometimes the simple way is the best way to get the message across.

     Thank you I think I like your idea about simply saying 60% return, let them sort out the accounting. We just want to show that adding our service is a good investment and had a good return. 

    0Reply
  • Julie Silvestro
    OP
    Peoria, AZ · Member since 2017 · 27 posts · 6 votes
    9y
    Originally posted by @Bruce Petersen:

    This feels or sounds like an MLM pitch someone hit me with couple years ago?

     It is not. It is simply a B2B Internet solution. Essentially the apartment owner buys and then owns the internet infrastructure and can charge the residents for Internet services, we also manage and operate the services so that it is a hands-off upgrade to the property.  It's like "Bulk internet" "bulk WiFi" or "wholesale managed Internet services" but has some very distinct differences technologically and ownership wise. 

    1Reply
  • Cooper Bert
    Harrisburg, PA · Member since 2015 · 43 posts · 52 votes
    9y
    Originally posted by @Julie Silvestro:
    Originally posted by @Bruce Petersen:

    This feels or sounds like an MLM pitch someone hit me with couple years ago?

     It is not. It is simply a B2B Internet solution. Essentially the apartment owner buys and then owns the internet infrastructure and can charge the residents for Internet services, we also manage and operate the services so that it is a hands-off upgrade to the property.  It's like "Bulk internet" "bulk WiFi" or "wholesale managed Internet services" but has some very distinct differences technologically and ownership wise. 

     @Julie Silvestro

    This reminds me of a problem we've run into regarding internet service to our SFR that we rehab and rent long term. Maybe you have a solution for it.

    We do not provide internet service to our tenants but we totally rewire our homes with 2Gig cable and high bandwidth distribution.  We also install the Schlage Connect internet ready, automated keyless entry doorsets.  These doorsets can be programmed by internet from any device (computed, tablet, phone, etc.).  The doorset has an alarm built-in for opening, unlocking, etc.  They allow us to remotely give repair contractors a one time code for property entrance, remotely open doors for locked out tenants, allow tenant parents to control/track the in/out of children, etc.  

    The problem is that the doorsets need internet wifi in order for use to use these features.  The tenant provides their own wifi and we do not want to ask them to provide us acces to their wifi system.  Any thoughts or solutions you might have for this issue?   Thanks.

    0Reply
  • Bruce Petersen
    Rental Property Investor · Austin, TX · Member since 2017 · 254 posts · 265 votes
    9y

    @Julie Silvestro, interesting concept.

    I hope I didn't come across rude, that was not intent.  Sorry if I did.

    0Reply
  • Steve Vaughan
    Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
    9y

    As an amenity to our young professionals (mostly) in our old brick apt bldgs, I started offering 'free wi-fi' and upped the rent for new folks $25/mo. The fiber optic service costs me $50/mo for every 4-5 units, so I do see a high ROI per dollar spent but my biggest benefit is no more dealing with yet another hook-up of new cable/satellite or internet service. The brick is a foot thick!

    All apt owners hate dealing with installers, a million dishes and siding blow-out. I'd address that pain point in my marketing as well, Julie!

    2Reply
  • David Faulkner
    Investor · Orange County, CA · Member since 2015 · 2k+ posts · 3k+ votes
    9y

    Definitely ROI ... saying that your service raises the CAP rate demonstrates that you either don't understand CAP rate or are trying to fool those that don't understand, and neither is good. Short of physically picking up a 10 unit apartment complex and moving it to another market, you can NOT change the CAP rate ... if you improve the NOI of a commercial property (5+ units), then you do NOT increase the CAP rate (which is set by the market), you instead increase the value of the property (Value = NOI/CAP). If you are trying to apply CAP rate to SFRs or under 5 unit buildings, and then saying your service will increase CAP, then you are using the term wrong twice.

    3Reply
  • Sam Shueh
    Real Estate Agent · Cupertino, CA · Member since 2016 · 4k+ posts · 1k+ votes
    9y

    Go back consult with commercial real estate finance 101 class. Redefine what you want to do.  No offence it is not clear to most of us.

    Sam Shueh, mba

    0Reply
  • Immanuel Sibero
    Carrollton, TX · Member since 2015 · 415 posts · 371 votes
    9y

    @Julie Silvestro

    Interesting to see the different takes that people have on this thread. My take is:

    - You're trying to market your service to apartment owners as an "investment".

    - It's a potentially high yielding investment so you want to effectively communicate this to apartment owners using their "lingo".

    - You found out that apt owners, in their lingo, frequently use "cap rate" as a measure of return on an "investment" whereby the higher the cap rate the higher the return.

    - So you're thinking - in my marketing, why don't I use the term "cap rate" to describe the potential high return of the service that I'm offering. Surely this will convey my message better than the term "ROI", after all just about every real estate investor knows what cap rate is.

    - So your question is: which is better -

    • Buy my service, it's an "investment" with 60% ROI... OR
    • Buy my service, it's an "investment" with 60% Cap Rate.

    If I have described your original question correctly, then my recommendation is scrap the cap... :-)

    Reasons:

    - As it is, there are already many investments marketed using "cap rate" where cap rate is totally irrelevant - single family residence, turnkey SFR's, duplex, triplex, etc. To market internet service with cap rate is kinda out there...lol

    - Cap rate is not even a measure of return.

    - You shouldn't think that you can actually connect better with real estate investors (i.e. apartment owners, in this case) by discussing cap rate. It's the most misunderstood metric, in my opinion.

    Cheers... Immanuel

    2Reply
  • Michael Le
    Developer · Houston, TX · Member since 2015 · 1k+ posts · 1k+ votes
    9y
    Originally posted by @Immanuel Sibero:

    @Julie Silvestro

    - Cap rate is not even a measure of return.

    Hi Immanuel, while I agree that cap rate is an often overused and misused term, I have to disagree with the above. The very definition of the capitalization rate is a measure of return. The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate, if the property were purchased with cash.

    0Reply
  • David Faulkner
    Investor · Orange County, CA · Member since 2015 · 2k+ posts · 3k+ votes
    9y
    Originally posted by @Michael Le:
    Originally posted by @Immanuel Sibero:

    @Julie Silvestro

    - Cap rate is not even a measure of return.

    Hi Immanuel, while I agree that cap rate is an often overused and misused term, I have to disagree with the above. The very definition of the capitalization rate is a measure of return. The capitalization rate is the rate of return on a real estate investment property based on the income that the property is expected to generate, if the property were purchased with cash.

    Total return = sum of all rental income + appreciation - sum of all expenses, over the life of the investment. Cap rate alone does not measure that ... it is a variable in the equation when you drill down for commercial property, but not a measure of the total.

    0Reply
  • Immanuel Sibero
    Carrollton, TX · Member since 2015 · 415 posts · 371 votes
    9y

    @Michael Le

    Fair enough.

    I think it boils down to our interpretation of the definition. To me a Capitalization Rate is a rate that capitalizes something (yeah took me forever to come up with that one... lol) ... presumably into something else (kinda like a conversion rate). In this case, it is a rate that takes each dollar of NOI and converts it (i.e. capitalizes it) to n dollar of VALUE. It's like saying - give me your NOI and I'll measure your VALUE. Based on this notion, this rate actually measures value.

    Now, mechanically you can always reverse the process whereby that same rate converts each dollar of VALUE into n dollar of NOI. It's like saying - give me your VALUE and I'll measure your NOI. In this case, yes I would agree that the rate effectively measures NOI (i.e. return). But I wouldn't call this rate "Cap Rate" because it doesn't capitalize anything.

    Another perspective I'm offering is if you could accept that Cap Rate is conceptually equivalent to Price Earnings ratio (P/E ratio) of a stock then it's easy to see that Cap Rate is not (or should not be) a measure of return because P/E ratio is never used as a measure of return of a stock investment. EPS (earnings per share) has that covered. As a matter of fact, P/E ratio is a measure of how expensive a stock is much the same way cap rates are a measure of how expensive a property is. 

    Immanuel

    0Reply
  • Michael Lee
    Investor · Coppell, TX · Member since 2008 · 2k+ posts · 646 votes
    9y

    Hello and welcome to BP! I lack very much experience bit I would tend to take ROI over Cap Rate because ROI is based more towards reality and the Cap Rate is more of a numer that has been used in this market area Eventhough you can get your own out of using reality Eventhough you are comparing your rate to what is supposed to be recommended in the area. I know that sounds confusing but it is my interpretation of it. Know that it is nicer to start out with a positive cash flow reprinted with the ROI being positive with your debt taken from it. I would look at both ROI and the CAp Rate but would tend to be more reliant with the ROI. Capital expenses tend to important on what you have to do versus getting a reserve account from a positive ROI after debt service has been made.

    The capital expenses are usually pretty big, especially if you are not ready for them with a long term reserve account. So do not be so greedy that tends to keep more money in your pocket instead of saving up for it in your reserve account. It helps to realize what is coming up and how much money will it take to cure that problem. Cap-Ex is harder on you than the ROI because the ROI is more of a budgeted amount and Cap-Ex tend to be more of an emergency expense. Some expenses that the Cap-Ex comes from have to be expensed over the long run than writing them all off the year that was spent. Just know that apartment properties are attempted to be sold on a retail basis using projection numbers instead of actual numbers. You tend to be lower because you want to buy at a discount based on actual numbers instead.

    Good luck to you!

    0Reply
  • Percy N.
    Developer · Philadelphia, PA · Member since 2015 · 2k+ posts · 904 votes
    9y
    Cap rates are typically used to quantify returns on physical real estate. You are not offering real estate and thus I would express your profit potential in terms of ROI. Now, it seems there are any questions that come to mind such as do I need to purchase or lease the equipment (routers, etc)? Who will do the installation? Who will provide technical support? Who will monitor the efficient working of the connection, etc?
    1Reply
  • Shawn Devoid
    Real Estate Agent · Tucson, AZ · Member since 2016 · 168 posts · 106 votes
    9y

    I see it as a vale-add alternative income-stream for residential investors achieving a 60% ROI.

    1Reply
  • Shawn Devoid
    Real Estate Agent · Tucson, AZ · Member since 2016 · 168 posts · 106 votes
    9y

    oops, value-add.

    0Reply
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