The capitalisation rate — commonly abbreviated as cap rate — is the ratio of a property's stabilised net operating income to its current market value. It functions as both a valuation tool and a market yield indicator, translating the income-producing capacity of a real asset into a rate directly comparable to other investment yields. Movements in the cap rate determine how changes in capital markets conditions propagate through to commercial real estate valuations.

Key takeaways

• The cap rate is NOI divided by value; an equivalent expression is value equals NOI divided by cap rate — making cap rate and value inversely related at constant NOI.
• Cap rates are market-determined; they reflect investor required return, current financing costs, perceived asset risk, and expected income growth — not a metric set by any individual party to a transaction.
• A 25-basis-point expansion in the market cap rate reduces the implied value of a stabilised asset by approximately four to five percent at typical cap rate levels; a 100-basis-point expansion reduces value by fifteen to twenty percent, illustrating the sensitivity of real estate portfolios to capital markets conditions.

The rate and its inverse

The cap rate formula is:

Cap rate = NOI ÷ market value

Rearranged:

Market value = NOI ÷ cap rate

At a cap rate of 5.0% and stabilised NOI of $1,000,000, the implied value is $20,000,000. At 6.0%, the same NOI implies a value of $16,667,000 — a reduction of $3,333,000 without any change in the income the property generates. The inverse relationship between the rate and the value is the core mechanism by which macroeconomic conditions affect real estate portfolios.

Components of the cap rate

Cap rates are market-derived through arm's-length transactions. Their level reflects several underlying factors:

Risk-free rate. The capitalisation rate for any income-producing real asset incorporates a spread over the risk-free rate (typically proxied by long-term government bond yields). When risk-free rates rise, cap rates tend to follow, with some lag and with varying degrees of pass-through depending on market conditions.

Risk premium. The premium above the risk-free rate reflects property-specific risks: illiquidity, asset management complexity, lease rollover exposure, physical obsolescence, and local market demand uncertainty. Higher-quality assets in core markets trade at lower cap rates (higher implied premiums over the risk-free rate are compressed because perceived risk is lower).

Income growth expectation. Assets where rents are expected to grow — because of supply constraints, strong tenant demand, or contractual escalation — trade at lower cap rates than assets with flat or declining rent prospects. The cap rate in effect incorporates the market's expectation of income trajectory, not only the current-period income.

Cap rate tiers by asset class

Commercial real estate markets are segmented, and cap rates vary systematically by property type, quality, and location. Institutional-quality, fully leased assets in core urban markets — primary office, prime neighbourhood retail, Class A logistics — have historically traded at cap rates below those applied to suburban or secondary-market assets of comparable size.

The cap rate differential between asset classes reflects not only risk perceptions but also the investor universe willing to acquire each asset type: institutional capital concentrates in certain asset classes and markets, increasing transaction volume and compressing cap rates in those segments.

Valuation under IFRS 13 and IAS 40

For entities that account for investment property under the fair value model (IAS 40), the market value of each property is assessed at each reporting date. IFRS 13 requires that fair value measurement use the highest and best use of the asset, and that valuation techniques incorporate observable market data to the maximum extent possible.

The direct capitalisation method — applying a market-derived cap rate to stabilised NOI — is a Level 3 valuation technique under the IFRS 13 hierarchy when comparable transaction data is limited. Entities using Level 3 inputs are required to disclose: the valuation technique applied, the significant unobservable inputs (including the cap rate assumed), the sensitivity of the fair value measurement to changes in those inputs, and a reconciliation of opening to closing fair value for each period.

Cap rate sensitivity disclosure — quantifying the effect of ±25, ±50, and ±100 basis-point shifts in the assumed cap rate on the reported fair value — is standard practice for investment property entities and is explicitly expected by institutional investors and securities regulators in management's discussion and analysis.

Market cap rate versus going-in and exit cap rates

In investment analysis, the cap rate is applied at two distinct points:

Going-in cap rate is the cap rate implied by the acquisition price relative to stabilised NOI at the time of purchase. It determines the entry yield on the investment.

Exit (or terminal) cap rate is the cap rate the analyst applies to projected NOI at the assumed disposition date to estimate terminal value. Because the cap rate at disposition is uncertain, sensitivity analysis across a range of exit cap rates is standard in underwriting.

The spread between going-in and exit cap rates reflects assumptions about the relative attractiveness of the asset at each point in time — a tightening exit cap rate assumption (lower cap rate at disposition) implies the analyst expects the asset to be more highly valued at exit than at entry, which may reflect expected income growth, market compression, or both.

See also

• net-operating-income — the numerator in the cap rate formula; the income stream that the cap rate converts to a value
• interest-rate-transmission — how risk-free rate movements propagate through cap rates to property values