What it means
The measure uses net operating income, which is rent after operating costs such as maintenance, insurance, management fees and an allowance for empty units, but before mortgage interest, tax and depreciation. Excluding financing is deliberate, since it lets two buyers with different borrowing arrangements compare the same building on identical terms.
Cap rates move inversely to prices, which is the single most useful thing to understand about them. The same $600,000 of income is worth $10,000,000 at a 6% cap rate and only $7,500,000 at 8%, so a rise in market cap rates cuts values even when rents are unchanged.
A low cap rate signals either a safe, sought after asset or an expensive one, and often both. A prime city centre office let to a government tenant on a long lease might trade at 5%, while a secondary industrial unit with a short lease and a shaky tenant could need 9% to attract a buyer.
In practice the rate gets used in two directions. Buyers divide a known income by a target rate to work out what they should pay, and valuers divide a known income by the rate observed in recent comparable sales to estimate what a building is worth.
The most important nuance is that a cap rate is a snapshot, not a return. It assumes the current income continues indefinitely, so it says nothing about rent reviews, an expiring lease or the roof that needs replacing in three years.
In practice
Real-world examples.
Example
A logistics fund sets a minimum acquisition cap rate of 6.5% and rejects a warehouse offered at 5.8%. The seller argues the tenant covenant justifies the price, but the fund's mandate requires the income yield rather than a bet on future growth.
Example
A family investor compares a residential block at 4.9% with a small business park at 8.2%. The higher rate reflects shorter leases and a greater chance of empty units, so the two are not really the bargain and the loser they first appear to be.
Example
A valuer estimating a care home's worth applies a 7% cap rate drawn from three recent local transactions to the home's $1,050,000 of net operating income, arriving at a value of $15,000,000. The lender uses that figure as the basis for its loan to value test.
Think of it
“Cap rate is the income yield on a property-how much you earn relative to price.
Formula
Calculation
Capitalisation rate = net operating income / property value x 100, and rearranged, property value = net operating income / capitalisation rate
An investor is looking at a small retail parade. Gross rent is $960,000 a year, and operating costs plus a vacancy allowance come to $360,000, so net operating income is $960,000 - $360,000 = $600,000.
The asking price is $8,000,000, which gives a cap rate of $600,000 / $8,000,000 = 0.075, or 7.5%.
If recent sales of comparable parades in the same town have traded at a 6% cap rate, the implied value of this one is $600,000 / 0.06 = $10,000,000, suggesting the asking price is $2,000,000 below the market rate and that the investor should look hard for the reason why.Case study
Seen in the real world.
The following is a fictional and illustrative example. Merrowfield Estates, an invented property partnership, bought a suburban office block for $12,000,000 on a 7% cap rate, with net operating income of $840,000 from a single tenant with six years left on its lease.
Four years later the fictional partners tried to refinance. Rents had not moved and income was unchanged, but with only two years left on the lease, buyers now wanted a 9% cap rate for the letting risk, implying a value of $840,000 / 0.09 = $9,333,333.
Nothing about the building or its cash flow had deteriorated, yet roughly $2,700,000 of value had evaporated because the market's required rate had risen. Merrowfield's illustrative mistake was treating a cap rate as a fixed property of the building rather than a moving market price for risk.
Watch out
Common mistakes.
- Calculating the rate using gross rent instead of net operating income, which inflates the apparent yield by ignoring running costs and empty periods.
- Deducting mortgage interest before working out net operating income, which mixes the property's performance with the buyer's financing choices.
- Treating the cap rate as the investor's return, when actual returns also depend on rent growth, financing and what the building eventually sells for.
Questions
People also ask.
What is a good cap rate?
There is no universal answer, since it depends on location, lease length and tenant quality, and rates commonly range from around 4% for prime assets to 10% or more for risky ones.
Why do cap rates rise when interest rates rise?
Because buyers can earn more elsewhere with less effort, so they demand a higher income yield from property, which pushes prices down.
Does the cap rate work for owner occupied premises?
Only with an estimated market rent, since the measure needs an income stream and an owner occupier does not pay itself rent.
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