The yield a property produces before financing
Capitalisation rate is net operating income divided by price. It measures the property, not the deal: it deliberately excludes the mortgage, so two buyers with different financing can compare the same building on the same basis.
The formula
Net operating income is rent minus operating costs — management, maintenance, insurance, property tax, vacancy allowance. It does not subtract mortgage payments, depreciation or income tax.
Worked example: $60,000 NOI on a $1,000,000 property
- Cap rate: 6.0%
- Read the other way: at a 6% market cap rate, that income stream is worth $1,000,000
That reversal is how commercial property is actually valued. Raise NOI by $6,000 through rent increases or cost cuts and, at an unchanged 6% cap rate, the building is worth $100,000 more. Small operating improvements move valuations by large multiples.
What the rate is telling you
| Cap rate | Typically means |
|---|---|
| 3–4% | Prime location, low perceived risk, priced for growth |
| 5–7% | Stable residential or commercial in a solid market |
| 8–10% | Secondary market, older stock, or shorter leases |
| Above 10% | Something is wrong, or the income is not durable |
A high cap rate is not a bargain. It is the market pricing risk, and the question is always which risk.
Why it excludes the mortgage
Two investors buy identical buildings. One pays cash, one borrows 70%. The cap rate is the same for both, because the building is the same. Their returns on capital are wildly different.
That separation is the point: cap rate compares assets, cash-on-cash return compares deals. Using cap rate to judge a leveraged purchase misses the entire financing question, and the debt service coverage ratio is where that gets answered.
What this calculator leaves out
Capital expenditure — roof, boiler, structural work — which is not an operating expense but is very much a cost. A 6% cap rate on a building needing $80,000 of work is not a 6% cap rate.
Also lease quality. The same NOI from a ten-year corporate lease and from month-to-month tenants is not the same income.
Cap rate against the cost of borrowing
When the cap rate exceeds the mortgage rate, borrowing raises your return on capital. When it is below, leverage works against you — every borrowed dollar earns less than it costs.
At a 6% cap rate and a 7% mortgage the spread is negative, and the deal only works on the expectation of rent growth or price appreciation. That is a bet on the future rather than on the income, and it should be named as one.
Where the rate comes from
You do not choose a cap rate; the market sets it, and it moves with interest rates. When government bond yields rise, investors demand a higher yield from property too, so cap rates rise and prices fall — with no change whatsoever in the rent.
A building producing $60,000 of NOI is worth $1,000,000 at a 6% cap rate and $857,000 at 7%. That $143,000 swing is the interest rate cycle, not the property, and it is why property values move without any tenant noticing.
Related calculators
- Net operating income calculator — the numerator, built up properly
- DSCR calculator — whether the income covers the borrowing
- Gross rent multiplier — the cruder screening ratio