Cap rate

Expanded explanation

The capitalisation rate expresses a property's annual operating income as a percentage of its value or purchase price. It is the commercial real estate equivalent of an unleveraged earnings yield: what the building itself produces, before financing.

Because it strips out debt, cap rate allows two properties with different mortgages to be compared on the same basis. It is used to price acquisitions, to estimate value from income, and to describe how the market is currently rewarding a given property type, location and lease profile.

A cap rate is a snapshot of one year's economics, not a return forecast. It says nothing directly about rent growth, capital expenditure, financing cost, or the price a future buyer will pay.

How it works

The formula is:

Cap rate = Net operating income ÷ Property value

Net operating income (NOI) is rental and other property income less operating expenses such as property taxes, insurance, management, maintenance and unrecovered utilities. It excludes mortgage interest and principal, depreciation, and income taxes.

Rearranged, the same relationship values a property from its income:

Value = NOI ÷ Cap rate

That inversion is why cap rates move prices. Holding income constant, a rise in market cap rates lowers value, and a fall raises it.

Key distinction

Cap rate vs. cash-on-cash return. Cap rate is unleveraged and describes the asset. Cash-on-cash return divides annual pre-tax cash flow after debt service by the equity actually invested, so it describes the investor's position, including the effect of borrowing. A property with a 6% cap rate can produce a higher or lower cash-on-cash return depending entirely on the loan.

Cap rate vs. internal rate of return. Cap rate is a single-period yield. IRR is a multi-period, time-weighted figure that incorporates rent growth, capital spending, financing and the eventual sale price. Marketing material that presents a cap rate alongside a projected IRR is describing two different things.

Why it matters

Cap rate is the single most common shorthand in commercial property, and it drives three practical judgements.

First, pricing: the difference between the cap rate at purchase and the cap rate assumed at sale ("exit cap") is often the largest swing factor in a deal projection. An exit cap assumed lower than the entry cap embeds an assumption that a future buyer will pay more per dollar of income.

Second, risk signalling: lower cap rates usually accompany assets perceived as more durable — strong locations, creditworthy tenants, long leases. Higher cap rates usually compensate for weaker demand, shorter leases, capital needs or thinner markets.

Third, rate sensitivity: cap rates tend to move with prevailing interest rates and required risk premia, so property values can fall even when rents are stable.

Common misconceptions

• "A higher cap rate is a better investment." A higher cap rate typically prices in more risk, more vacancy exposure or more capital expenditure. It is compensation, not free yield.
• "Cap rate is my return." It ignores debt, taxes, capital reserves, transaction costs and any change in value.
• "NOI is standardised." It is not. Whether management fees, reserves for roof and parking replacement, or tenant improvement costs are deducted varies by sponsor, and each choice changes the stated cap rate.
• "Cap rates apply to any property." For owner-occupied homes and for developments without stabilised income, the measure has little meaning.

Where readers encounter it

Cap rates appear in private real estate offering documents, crowdfunding platform listings, REIT investor presentations, appraisal reports and broker marketing packages. Investors in listed REITs meet a close relative, the implied cap rate, which divides portfolio NOI by the REIT's enterprise value and is used to judge whether shares trade above or below private-market property pricing.

Appraisers separate the going-in cap rate from the terminal cap rate and reconcile the income approach with sales-comparison and cost approaches. Underwriters normalise NOI before applying a cap rate: they mark rents to market, apply a vacancy and credit-loss factor, and deduct a per-square-foot capital reserve that sellers often omit.

Analysts also watch the spread between property cap rates and long-term Treasury yields as a rough risk premium. When that spread compresses, property is priced for little cushion against rising rates. Aggregate real estate values and mortgage debt are tracked in the Federal Reserve's Z.1 financial accounts, which is the standard reference for market-wide leverage context.