If you’re new to commercial real estate, you might have heard the phrase “cap rate”. In short, a cap rate is a percentage value representing how much income your property delivers as a proportion of its value.
In this blog, we’ll define what a cap rate is, help you understand what affects it, how you can calculate it, and give you guidance on how to use it to make better decisions for you and your investment portfolio.
What is a Cap Rate in Real Estate?
A capitalisation rate (cap rate) represents the ratio of a property's net operating income (NOI) to its current market value. The fundamental formula for calculating it is:
Cap Rate = Net Operating Income (NOI) / Property Value × 100%
There are a few nuances that you should be aware of:
- NOI includes income after operating expenses but before interest payments and taxes.
- Operating expenses include property management, insurance, maintenance, and property taxes.
- Cap rates directly reflect the risk-return profile of your commercial investment.
Cap rates are the industry standard metric used by commercial appraisers and sophisticated investors alike so, if you’re a serious investor, it’s key for you to use and understand them.
Understanding Cap Rates: Risk and Value Relationship
The inverse relationship between cap rates and property values stems from fundamental risk principles in real estate investing. A lower cap rate signals lower perceived risk, which commands a higher property value. This happens because investors are willing to accept lower returns (the cap rate) when they feel more confident about the stability and reliability of the income stream.
Properties with strong tenants, long-term leases, prime locations, and stable cash flows typically have lower cap rates because they offer predictable income with reduced risk exposure. Conversely, higher cap rates indicate greater risk, requiring higher returns to compensate investors for uncertainty, which results in lower property valuations. This risk-value relationship makes cap rates a crucial metric for analysing commercial real estate opportunities and comparing investments across different markets and property types.
Is a Higher or Lower Cap Rate Better?
Cap rates fundamentally represent risk measurements in commercial real estate. Whether a higher or lower cap rate is preferable depends entirely on the investor's risk tolerance. Higher cap rates indicate greater investment risk but potentially higher returns, while lower cap rates signal reduced risk with typically more modest returns. Your investment goals and risk comfort level should guide your cap rate preferences.
Cap Rate vs. Rental Yield: Critical Differences
Unlike cap rate, rental yield focuses specifically on rental income. You can either calculate your Gross Rental Yield (rent as a percentage of property value), or the Net Rental Yield (the profit on rent over and above expenses):
- Gross Rental Yield = Annual Rental Income / Property Value × 100%
- Net Rental Yield = (Annual Rental Income - Expenses) / Property Value × 100%
Key Differences
Apart from the fact that one is used in residential and the other in commercial property, the most important differences here are:
- Expense Calculation: Cap rate uses NOI which always accounts for all operating expenses whereas, if you use Gross Rental Yield, it doesn’t consider expenses at all.
- Income Basis: Cap rate calculations typically involve multiple tenants and complex lease structures, while Rental Yield involves simpler residential leases.
- Professional Usage: Cap rate is widely used by commercial investors and appraisers as an industry standard, while Rental Yield is often used by individual residential investors.
- Market Comparison: Cap rate better reflects the complexity of market conditions and risk, while Rental Yield is more useful for comparing residential investments.
Cap Rate vs. Return on Investment (ROI)
The key distinction between cap rate and ROI lies in timing and calculation scope. ROI projects potential returns over a specific future timeframe, accounting for all factors including financing and appreciation. Cap rate, by contrast, measures a property's current performance based on existing NOI relative to value, providing a snapshot of present yield without considering financing or future value changes.
Commercial Property Types and Their Cap Rates
Risk varies depending on the type of property and cap rate values will vary in turn. Let’s look at the four most common types:
1. Office Properties
Properties in a Central Business District (CBD) typically show a lower cap rate because of higher property values and lower risk. Suburban office spaces, in contrast, generally command higher cap rates as investors seek higher returns on a riskier asset.
2. Retail Properties
In retail, neighbourhood centres generally have higher cap rates than regional malls due to smaller tenant profiles and higher turnover. While e-commerce has increased risk for many retailers, pushing up cap rates for some, it has also driven demand for experience-based shopping centres, keeping cap rates low for others. The lowest cap rates tend to come with longer leases, strong tenants (e.g. big brands), and in prime locations.
3. Industrial Properties
For industrial property, logistics facilities typically have strong demand, long leases and, therefore, lower cap rates than manufacturing spaces, especially when located near major transport hubs. Modern facilities built with premium specifications attract high-quality tenants and lower cap rates, whereas older properties with inefficient design and layout may struggle to attract a multi-national tenant, leading to higher cap rates.
4. Specialty Commercial
Specialty commercial properties encompass unique asset classes that fall outside traditional commercial real estate categories. These include hotels and hospitality venues, data centers, self-storage facilities, healthcare properties (such as hospitals and medical centers), senior living communities, student housing, entertainment venues, and specialised industrial facilities.
The cap rates for specialty properties are heavily influenced by two primary factors:
- Income Stability and Predictability: Properties with documented history of consistent revenue streams and manageable expense ratios typically command lower cap rates. For example, a data center with long-term service contracts will generally have a lower cap rate than a seasonal resort hotel with fluctuating occupancy rates.
- Tenant Quality and Credit Profile: The financial strength of tenants significantly impacts risk assessment. Properties leased to financially robust tenants (such as ASX-listed companies with parent company guarantees) warrant lower cap rates than those occupied by less established entities. Sophisticated investors thoroughly examine tenant financial statements, credit ratings, and corporate structures when evaluating specialty assets.
Market positioning also matters—specialty properties in prime locations with modern amenities and sustainable features generally secure premium tenants and more favorable cap rates. For instance, a newly constructed medical office building leased to a major healthcare system or a government tenant will typically command a lower cap rate than an aging facility with independent practitioners on short-term leases.
What Factors Influence Cap Rates?
Cap rates are affected by both external factors and property fundamentals. Instability generally means higher cap rates, both because investors look for bigger margins to cover their risk and because riskier properties are lower in value.
Interest Rate Environment
1. RBA Monetary Policy: Cash rate adjustments and cap rate movements correlate with a lag of around 3-6 months. Historically, a 1% RBA rate change leads to a 0.5 percentage point cap rate change. Retail is typically most sensitive to these adjustments due to its greater exposure to consumer spending patterns.
2. Bond Yield Correlations: 10-year Australian Government Bond yields serve as the benchmark for risk-free investments and function as a leading indicator for cap rates. Historically, cap rates have maintained a spread of 2-4 percentage points above 10-year bonds, reflecting the risk premium investors require for commercial property investments.
3. BBB- Corporate Bond Correlation: BBB- corporate bond yields show the strongest correlation with commercial real estate cap rates among fixed income securities. As the lowest tier of investment-grade debt, BBB- bonds capture similar risk sensitivities to commercial property investments. The spread between cap rates and BBB- yields (the "property risk premium") typically narrows during stable economic periods and widens during uncertainty. Property-specific factors like location quality, tenant credit, and lease terms influence this spread across different market segments.
4. Debt Financing Costs and Serviceability: Rising interest rates lead to tighter lending conditions and more expensive fixed-rate loans. This upward pressure on financing costs drives cap rates higher as investors demand improved yields to offset increased borrowing expenses. Critically, higher interest rates directly impact debt serviceability metrics—the Interest Cover Ratio (ICR) becomes increasingly constrained as debt service payments consume a larger portion of operating income. With reduced free cash flow after debt service, investors cannot justify lower cap rates in their valuations. Lenders typically require minimum ICR thresholds (often 1.5x to 2.0x), forcing investors to either accept lower leverage or demand higher cap rates to maintain viable debt service coverage. This dynamic particularly affects highly leveraged investments and properties with tight operating margins, creating a compounding effect that pushes cap rates upward across markets.
Capital Market Implications
When interest rate differences between countries go up, it can increase or reduce cross-border investment as investing in Australia becomes comparatively cheaper or more expensive. The same happens if market conditions push investors to invest in one type of property over another. Anything that reduces demand can push up cap rates.
Location Quality
Location has a big impact. Here are four factors to consider:
1. Prime vs. Secondary Markets: In a prime CBD or other high-demand location, cap rates are typically lower. Asset prices are higher, tenant demand more reliable, and risk lower (prime assets show 40% less volatility historically).
2. Growth Corridor Positioning: Being within a government-designated urban growth boundary can deliver employment and population growth, both of which contribute to demand, better commercial property performance, and lower cap rates.
3. Infrastructure Access: Public transport, major roads, and airports increase access and create demand, reducing cap rates, typically by 25-75 basis points. The same is true of digital infrastructure.
4. Emerging Location Considerations: ESG location factors such as climate resilience and sustainability credentials also increase demand and reduce cap rates.
Tenant Profile
Your tenants also have a big impact on your cap rate. Tenants that offer stability compress cap rates. Here are three areas to consider:
1. Reliable tenants from stable sectors can reduce cap rates, for example ASX-listed or government tenants, or those with strong financial metrics and payment histories.
2. Long-term leases give you security, generally meaning lower cap rates. Committed terms, fixed rate rental increases, ratchet clauses, near-term market rent reviews, and triple-net lease arrangements all reduce cap rates.
3. The more diverse your tenants, the greater your stability and the lower your cap rate. A strong anchor tenant helps, but overreliance on one tenant is risky. Improving tenant quality and investment encourages renewals, while staggering lease expiry profiles gives you more stability.
Commercial properties require investors to emphasise NOI quality, reliability, and tenant credit risk. Properties with documented financial histories showing stable revenues and expenses typically command lower cap rates. The financial strength of tenant entities is crucial—properties leased to ASX-listed companies with parent company guarantees (rather than subsidiaries) warrant lower cap rates due to reduced default risk.
Investors should review tenant financials, credit ratings, and corporate structure when evaluating assets, as these factors significantly influence risk assessment and cap rate determination. Ultimately, income predictability and tenant creditworthiness—more than property type alone—determine where a property falls on the cap rate spectrum.
Property Attributes
The nature and quality of your property also have an impact on your cap rate. Factors that reduce cap rates include:
- Premium buildings, that are modern or with recent refurbishment.
- Environmentally friendly buildings.
- Premium areas and prime locations.
- Smart building management systems and high-speed connectivity infrastructure like 5G and fibre-optic internet.
- Advanced security systems and strong risk assessment frameworks.
Using Cap Rates for Investment Analysis
As an investor, cap rates serve multiple analytical functions.
1. Comparative Market Analysis: cap rates help you benchmark against market averages, track market trends, and identify potential value opportunities.
2. Risk Assessment: Higher cap rates can signal higher possible risk, especially in more volatile sectors, indicating a need for higher returns to cover your risks.
Valuation Methodology
You can use the industry cap rate to calculate other values that will be important to you as an investor:
1. Direct Capitalisation Approach
If you have the sector cap rate average, you can calculate the value with this formula:
Value = NOI ÷ Cap Rate
You need to consider that a property will typically need 6-12 months to reach a normal level of income and that rents may need to adjust. Also consider:
- Vacancy rates
- Operating expenses variability
- Capital expenditure reserves
- Leasing fees
- Management fees
2. Relationship to Discounted Cash Flow Analysis
Discounted Cash Flow (DCF) analysis helps you estimate a property’s value based on the income it could generate in future. Start by looking at recent sales of similar properties to calculate their cap rate and estimate your property’s future sale price. Then, adjust it to today’s value using a discount rate (usually the cap rate plus a bit extra for risk).
3. Reversionary Yield Considerations
You can use the industry cap rate to assess a property's future income potential. If the property is over-rented, with contracted rent above market values, income may drop when leases expire; if under-rented, there’s potential for growth.
Lease expiries, tenant retention rates, and re-leasing costs all impact future cashflow. Investors typically expect a reversionary yield of 25–50 basis points above the going-in yield, to also reflect higher NOI growth over time, adjusting their cap rate expectations accordingly when valuing the property.
Solutions for Commercial Property Investors
What does this mean for you as an investor? It means that if you’re going to understand your market, prospects, and risk, you need to monitor your cap rates carefully. Start with these three steps:
1. Maintaining Investment Discipline
One way to understand cap rates is to hold and think long-term. Instead of lurching around with every short-term change, you can recognise that cap rates have been gradually coming down for the past three decades (1995-2025), as interest rates have fallen, driving higher property values.
Instead of looking at short-term shifts, you can look at historical reference points such as sector-specific historical ranges, long-term average cap rates, regional variations, 10-year bond yields, and how markets have reacted to previous shocks.
2. Recognising Compression/Expansion Cycles
It’s also important to remember cap rates typically go through 7-10 year cycles between peaks. In the early part of a cycle, transactions generally increase around 25%, until debt-to-income ratios hit 15% towards the end of a cycle, usually preceded by interest rates going up. cap rate floor theory states that prime assets rarely sustain lower than 4.0-4.5% regardless of market conditions, and there are always opportunities in submarkets.
3. Risk Premium Assessment
Cap rates reflect not just income but also risk, which varies by property type, location, NOI quality, and tenant profile. Investors apply risk premiums to account for factors like liquidity (ease of selling), management intensity, and potential value fluctuations over time. Properties with higher perceived risk require higher cap rates to compensate investors for assuming that additional uncertainty.
Prime CBD offices typically command lower risk premiums, while regional properties carry higher premiums due to demand uncertainty and market liquidity concerns. Properties leased to blue-chip companies with strong covenant strength reduce risk exposure, while factors such as lease duration, rent review mechanisms, and market volatility directly influence the premium investors require, ultimately shaping cap rates across different asset classes.
Ultimately, your interpretation of cap rates should align with your investment objectives. A lower cap rate on a high-value property generally indicates a stable investment with predictable income streams and lower volatility. Conversely, a higher cap rate may signal elevated risk but offers correspondingly higher potential returns. By understanding the fundamental drivers of cap rates and their relationship to broader market cycles, you can make more informed investment decisions - whether acquiring, divesting, or maintaining your commercial property portfolio.
How Futurerent Can Support Your Investment Strategy
For residential property investors looking to optimise their commercial real estate ventures, Futurerent offers a unique solution that complements your investment strategy.
While Futurerent works exclusively with residential investment properties, the funds accessed can be strategically deployed toward commercial property investments. This loan-free financing alternative allows you to leverage the stable income from your residential portfolio to capitalise on commercial opportunities without impacting your credit score or incurring traditional debt. By accessing up to $100,000 per residential property (and up to $500,000 across your entire residential portfolio), you can strengthen your position when negotiating commercial property acquisitions, fund renovations, or address short-term capital needs without the lengthy approval processes associated with traditional financing.
