A Cap Rate Is One Year of Income Over the Price
Dividing a property income by its price gives the capitalisation rate. It is the standard measure in commercial property and it hides every assumption that actually matters.
The Definition
The capitalisation rate is net operating income divided by property value. Net operating income is rental income less operating expenses, before financing costs and before capital expenditure.
A building generating one million of net operating income and selling for twenty million transacts at a five percent cap rate.
Why It Is Used
It provides a single comparable number across properties of different sizes, which is genuinely useful for observing market pricing. Transaction cap rates reveal what buyers are paying for income in a location and sector at a moment.
A cap rate is the inverse of a multiple. A five percent cap rate is twenty times income, and framing it that way makes clearer how much is being assumed.
What It Leaves Out
| Omitted | Why it matters |
|---|---|
| Income growth | A growing income justifies a lower cap rate |
| Capital expenditure | Roofs and systems are not in NOI |
| Lease expiry profile | Income may end sooner than assumed |
| Tenant credit | Income is only as good as who pays it |
Capital expenditure is the most consistently underestimated. Net operating income excludes the cost of replacing building systems, re-letting space, and tenant improvements, all of which are real recurring cash costs. A property with a five percent cap rate and heavy upcoming capital needs yields considerably less than five percent to its owner.
The lease profile matters just as much. A building fully let for fifteen years to a strong tenant and one let for two years to a weak tenant can show identical current income and are not remotely the same asset.
What Drives Cap Rates
Cap rates move with interest rates, since property competes with bonds for capital, and with expected growth and perceived risk.
The relationship with rates is real and looser than commonly assumed. Cap rates did not rise one for one when rates rose, partly because sellers refused to transact at lower prices, which reduces transaction volume rather than immediately repricing the market.
That produces a specific difficulty: in a falling market, observed cap rates are stale because only the properties that had to sell are transacting, and appraisals based on those transactions lag reality.
Cap Rate Compression and Expansion
When cap rates fall, values rise without any change in income. That is compression, and a great deal of property return in low rate periods came from it rather than from operating improvement.
That distinction is essential when assessing a track record. A manager who bought at a six percent cap rate and sold at four made money on repricing, which is a market outcome. One who raised income substantially improved the asset, which is a skill.
How to Use It Properly
Treat the cap rate as a starting observation rather than a valuation. Ask what the income will be in five years given the lease profile, what capital spending is required to sustain it, and how the tenant credit compares to the yield.
Then compare the resulting cash yield to what a bond of similar duration and credit would pay. That comparison, rather than the headline cap rate, is what tells you whether the price is sensible.
The Bottom Line
The cap rate is one year of pre capital income over price, which makes properties comparable and conceals growth, capital requirements, lease expiry, and tenant quality. Compression can produce returns that look like performance and are really repricing, and in falling markets observed cap rates lag because only forced sellers transact.