What is a Cap Rate? Property Yield and Value

A cap rate, short for capitalisation rate, expresses a property’s annual net income as a percentage of its value or purchase price. In commercial real estate, valuers also use it to convert an assessed income into an indicated property value. The income basis and the selected rate must match for that calculation to be useful.

For a broker, the rate helps explain how the valuation treats the property’s income and risk. It doesn’t establish how much the client can borrow.

What a Cap Rate Measures

A cap rate measures annual property income relative to the capital value of the property, before the owner’s financing costs. The calculation needs an annual income figure and a value or purchase price for the same property interest.

For the examples below, annual income means net operating income: rent after the property’s operating expenses, before loan repayments and the owner’s income tax. A valuation can use assessed market income or a normalised income instead of the rent collected last year. Read its stated basis before reproducing the percentage.

The Royal Institution of Chartered Surveyors (RICS) describes income capitalisation as applying a rate to representative single-period income. That is different from a discounted cash flow calculation, which models income and costs over several future periods.

These measures answer different questions.

Measure	Calculation or basis	What it tells you
Cap rate	Annual net property income divided by property value	Income relative to the whole property’s value
Gross rental yield	Annual gross rent divided by price or value	Rent relative to value before property expenses
Loan interest rate	Interest charged on the loan balance	The cost of borrowed money
Leveraged return	Return after financing, measured against the investor’s equity	The investor’s outcome after using debt

A 6% cap rate and a 6% loan interest rate apply to different amounts. Matching percentages alone don’t show whether the rent covers repayments. An investor’s total return can also include a gain or loss when the property sells.

Calculate and Reverse the Formula

Calculate a cap rate by dividing annual net income by property value, then multiplying by 100. Reverse the formula by dividing that income by the cap rate expressed as a decimal.

This fictional example uses Australian dollars. Assume a leased property earns $150,000 annual rent and incurs $30,000 of operating expenses borne by the owner. It has no vacancy or outstanding incentives, and its stated value is $2,000,000.

The annual net income is $150,000 minus $30,000, which equals $120,000.

Cap rate = $120,000 / $2,000,000 x 100 = 6%.

Using gross rent instead would give 7.5%. That is the gross rental yield for this example, and using it as the net cap rate overstates the income return.

Now assume the same $120,000 annual net income and a selected cap rate of 6%. Convert 6% to 0.06 before dividing.

Indicated value = $120,000 / 0.06 = $2,000,000.

Dividing by 6 would give $20,000, an incorrect result caused by treating a percentage as a whole number. The calculation above also assumes no further valuation deductions. A valuer can make separate adjustments after capitalising income, so the formula result needn’t equal the report’s final value.

Check the Income Assumptions

Check the income figure against the leases and property accounts before carrying the cap rate into the finance case. A stated annual rent can differ from both cash received and the income capitalised by the valuer.

Australian valuer Sebastian Fox explains how commercial valuation adjustments account for lease terms and the cost of filling vacant space. Use the valuation’s treatment of each item when you reconcile its income.

Item	What to reconcile
Vacancy	Distinguish rent from occupied space from assumed rent for vacant space. Identify any lost-rent or letting-up deduction.
Incentives	Find rent-free periods, rent reductions and fit-out contributions in the lease or side agreement. Check how they affect effective income or deductions.
Recoverable outgoings	Match tenant reimbursements to the expenses they cover. Count each recovery once and retain expenses the owner must pay.
Lease expiry	Compare the remaining term with the income period. Identify assumptions about renewal, downtime and reletting costs.
Normalisation	Explain adjustments from actual income to a representative ongoing income, including market-rent assumptions and unusual expenses.

Record the valuation’s annual income beside the lease schedule and the matching accounts period. Then list each adjustment between those figures with its amount and document reference. For example, a rent-free period explains why the lease’s annual rent exceeds current cash receipts.

Ask the valuer to explain a difference that the report doesn’t resolve. Avoid deducting an incentive from income again if the valuation already deducts its value separately.

The International Valuation Standards property chapter says significant supplied inputs should be considered, investigated or corroborated. It also distinguishes property interests and the rights affected by leases. For lending, keep the report’s valuation date, assumptions and final value with this reconciliation.

Interpret a Changing Cap Rate

A higher cap rate produces a lower indicated value when annual income stays constant. A lower rate produces a higher value. These fictional calculations hold annual net income at $120,000 and assume no further deductions.

Assumed cap rate	Calculation	Indicated value
5%	$120,000 / 0.05	$2,400,000
6%	$120,000 / 0.06	$2,000,000
7%	$120,000 / 0.07	About $1,714,286

Moving from 6% to 7% reduces indicated value by about $285,714, or 14.3%, with no income change. These rates illustrate the arithmetic. They are not observed market yields or recommended investment targets.

What is a Good Cap Rate?

A suitable cap rate is one supported by comparable transactions and the property’s income risks on a consistent basis. A higher percentage alone doesn’t establish a better investment. It can reflect less secure income or a lower price.

Compare the property type and location with the evidence used in the valuation. Check the transaction dates and differences in lease terms, tenant reliability and building condition. A yield extracted from gross rent cannot be compared directly with one based on net income.

The valuer’s method also matters. A changing lease income may need a detailed cash flow model, while a single cap rate compresses those assumptions into one income-and-rate relationship. Reproduce the report’s calculation before interpreting its result.

Use the final valuation alongside the client’s repayment capacity in the commercial property loan assessment. Keep a sensitivity calculation separate from the value the lender accepts, so an illustrative rate change doesn’t become an unsupported loan amount.