Capitalisation Rate

The capitalisation rate, usually shortened to cap rate, is a measure used in real estate that expresses a property's annual net operating income as a percentage of its value. It indicates the unleveraged yield an investor would earn in the first year if the property were bought for cash. Investors, lenders and valuers use it both to compare properties and to convert an income figure into an estimate of value.

A cap rate plays a similar role in real estate to that of an earnings yield in the share market. It is a snapshot based on a single year's income, and it ignores financing, tax and future growth. In British usage the nearest equivalent terms are the net initial yield and the all-risks yield.

The standard calculation is:

• Net operating income is the annual rent and other income from the property, less vacancy allowances and operating expenses such as maintenance, insurance, management and property taxes. It is stated before debt service, depreciation and income tax. See net operating income (NOI).
• Property value is the current market value or the purchase price.

An office building that produces net operating income of 500,000 a year and sells for 8,000,000 has a cap rate of 500,000 divided by 8,000,000, or 6.25%.

The formula is more often used in reverse, to estimate value from income, a method known as direct capitalisation:

If comparable buildings have recently sold at a cap rate of 5%, the same income of 500,000 implies a value of 10,000,000. At 6.25% it implies 8,000,000. Small changes in the rate therefore cause large changes in value, and value moves in the opposite direction to the rate.

A cap rate can be understood as the return investors require, less the growth in income they expect. If investors demand a total return of 8% a year and expect income to grow by 2% a year, they will pay a price that gives an initial yield of about 6%. The main influences are:

• Interest rates. Cap rates tend to rise and fall with the risk-free rate on government bonds, though with a lag and not one for one.
• Risk. Investors add a risk premium for illiquidity, tenant default, lease length and the condition and location of the building.
• Expected growth. Markets with strong rental growth prospects trade at lower cap rates.
• Property type and quality. Prime buildings in major cities with long leases to strong tenants command the lowest rates; secondary assets command higher ones.
• Capital flows. The weight of money seeking property, and the availability of debt, affect pricing.

A falling cap rate is often called compression, and a rising one expansion. When interest rates rose sharply from 2022, cap rates expanded in most markets and commercial property values fell.

The income figure can be defined in several ways, and the label should say which. A going-in or initial cap rate uses the income at the time of purchase. A forward cap rate uses income projected for the next twelve months. A stabilised cap rate assumes the property is let at normal occupancy. A terminal or exit cap rate is the rate assumed at the end of a holding period in a discounted cash flow model, to estimate the sale price; it is usually set a little higher than the initial rate to reflect the building's greater age.

The cap rate should not be confused with the discount rate or the internal rate of return (IRR). Those measure the total return over the holding period, including growth and sale proceeds, and are generally higher than the cap rate.

Lenders apply their own cap rate to a property's income to arrive at a conservative value for calculating the loan-to-value ratio (LTV). They use it alongside the debt service coverage ratio (DSCR) and the debt yield, which is net operating income divided by the loan amount and can be compared directly with market cap rates. Rating agencies do the same when assessing loans in commercial mortgage-backed securities (CMBS), typically using rates above those prevailing in the market so that the analysis holds through a downturn. Listed property companies, including a real estate investment trust (REIT), are compared using an implied cap rate derived from their share price.

The cap rate depends entirely on the quality of the income figure. Sellers may present income that includes above-market rents about to expire, or expenses that understate what a new owner will pay. Different practitioners treat items such as capital reserves, leasing costs and management fees differently, so quoted rates are not always comparable.

As a single-year measure, the cap rate says nothing about how income will change. It works well for a fully let building with stable, long leases and poorly for a vacant, development or short-lease property, where a multi-year cash flow analysis is needed. It also ignores the effect of borrowing, which can raise or lower the return on the investor's own equity. Valuers therefore use it as one input to an appraisal report, together with comparable sales and discounted cash flow analysis.