The capitalisation rate is the standard shorthand for pricing income-producing property. It compresses a great deal of information into one number, and hides an equal amount.
The definition is narrow and specific
A cap rate divides net operating income by the property's price or value. Net operating income means rent received less the costs of running the building, before financing and before tax.
Excluding financing is deliberate, because it allows two buildings to be compared on their own merits regardless of how any particular buyer intends to fund the purchase.
It also means the figure says nothing about what a leveraged buyer would actually earn, which depends entirely on borrowing costs and the amount borrowed.
A low rate means a high price
Since income sits on top of the fraction and price beneath it, a lower cap rate corresponds to a buyer paying more for each unit of income.
Low rates therefore cluster around properties the market considers safe: strong locations, long leases and creditworthy tenants where the income stream is unlikely to be interrupted.
Higher rates appear where income is less certain, whether through weaker tenants, shorter leases, older buildings or locations with thinner demand.
The rate embeds growth expectations
A buyer accepting a low current yield is generally expecting rents to rise, because the initial income alone would not justify the price paid.
Where rents are expected to stagnate or fall, buyers demand a higher initial yield as compensation, which shows up as a higher cap rate.
This is why the same building can trade at very different rates in different periods without any change to the lease or the tenant.
Interest rates move the whole range
Property competes with bonds for capital, so when yields on government debt rise, the return demanded from property rises alongside them.
Cap rates across a market therefore drift upward as rates rise and compress as they fall, which changes valuations even where income is entirely unchanged.
Much of what looks like a property market cycle is this repricing, operating on income streams that were fixed by leases signed years earlier.
What the number leaves out
Capital expenditure sits outside net operating income in most conventions, so a building needing major works can show an attractive rate while consuming cash.
The measure is also a single snapshot, taking no account of lease expiry timing, which determines when income is at risk of resetting or disappearing.
Cap rates are useful for comparing similar assets in the same market at the same moment. Used across different types or periods, they mislead more than they clarify.