Cap Rates Explained: Formula, Example & What's a Good Rate

The capitalisation rate, or cap rate, is the first number most investors reach for when they weigh up a commercial property. It sets the property's net operating income against its price in a single percentage, which is why it travels so well across different locations, sizes and sectors. The trouble is that a figure this simple gets misunderstood and misapplied often. Used well, it tells you a great deal about risk and return. Used carelessly, it flatters a bad asset and hides a good one.

1 What Is a Capitalisation Rate?

A cap rate expresses the relationship between a property's net operating income and its purchase price or market value. The formula is simple:

Cap Rate = Net Operating Income / Purchase Price x 100

Take a commercial property that generates $120,000 in net operating income a year and sells for $2,000,000. The cap rate is:

$120,000 / $2,000,000 x 100 = 6.0%

Net operating income (NOI) is gross rental income less all operating expenses the landlord carries: council rates, water, insurance, land tax, body corporate fees and property management costs. It excludes mortgage repayments, depreciation and income tax, which vary from one investor to the next and say nothing about the property itself.

Put plainly, the cap rate answers one question: if you paid cash for this property, what annual return would the net rent alone give you?

2 What the Cap Rate Tells You

The cap rate measures return and risk together. A higher cap rate means more income return per dollar of price, and usually more risk. A lower cap rate means less income return and, generally, a safer asset.

That inverse relationship between yield and risk sits at the heart of commercial property valuation. A prime-grade CBD office with a long-term government tenant trades at a lower cap rate than a secondary industrial shed in a regional town let short-term to a small business. The first income stream is considered more reliable, so buyers accept a lower yield to hold it.

• Low cap rate (e.g., 4% to 5%): Usually a high-quality asset: strong tenant covenant, long lease term, prime location, lower perceived risk. Buyers accept the lower yield because they trust the income to hold and to grow.
• High cap rate (e.g., 7% to 9%): Often a secondary asset, a shorter lease, a weaker tenant, a less desirable location, or something else that puts uncertainty into the income. The higher yield is the compensation for wearing that risk.

A high cap rate is not better than a low one on its own. It comes down to your risk tolerance, your strategy, and whether the extra yield actually pays you for the risks involved.

3 Typical Cap Rate Ranges in Australia

Cap rates vary widely by asset class, location, tenant quality and lease profile. The ranges below are a general guide for Australian commercial property, though individual assets can sit outside these bands depending on their own characteristics.

• Industrial: 4.5% to 6% for prime metropolitan assets, with secondary stock and regional locations ranging higher.
• Office: 5% to 7% for metropolitan fringe and suburban assets. CBD prime grade trades at tighter yields, while secondary stock in weaker locations can exceed 8%.
• Retail: 5.5% to 7% for neighbourhood and sub-regional centres, with wide variation driven by tenant mix, lease profile and trade-area demographics.
• Medical and childcare: 5% to 6% for well-located assets on long-term leases to established operators, reflecting the essential-service nature of the tenancy and the stability of demand.

These bands shift over time with broader market conditions, interest rate movements and sector-specific dynamics. Cap rates compressed hard across every sector through the low-interest-rate period, and have since adjusted as borrowing costs have risen.

4 What Moves Cap Rates

Cap rates are not fixed. They move as the perceived risk of an asset or the wider investment environment changes, and a handful of forces do most of the work.

Interest rates are the big one. The link is general rather than perfectly correlated, but when borrowing costs rise, cap rates tend to expand (move higher), because investors want a greater spread between their cost of debt and their property yield; when interest rates fall, cap rates tend to compress. Supply and demand pull in the same way: strong investor demand for a sector or location pushes cap rates lower as more capital competes for the same pool of assets, while weaker demand, whether from economic conditions, sector concerns or oversupply, pushes them higher. Tenant quality feeds straight into pricing, since a property leased to a national tenant with strong financial standing trades at a tighter cap rate than the same building leased to a smaller, less established business; the tenant's creditworthiness sets the perceived reliability of the income. So does the WALE (weighted average lease expiry): longer remaining lease terms give greater income certainty and cut the near-term risk of vacancy, so a long WALE trades tighter than a short one. Location does the rest, with prime sites backed by infrastructure, transport access and tenant demand commanding tighter cap rates than secondary or tertiary locations, reflecting lower vacancy risk and stronger rental growth prospects.

5 Cap Rate vs Gross Yield

Cap rates and gross yields are related but distinct, and confusing the two is a common error among less experienced investors.

Gross yield is gross rental income divided by the purchase price, with no deduction for operating expenses. A property earning $150,000 in gross rent and costing $2,000,000 shows a gross yield of 7.5%.

Cap rate uses net operating income, which is gross rent less all operating expenses the landlord carries. If those expenses total $30,000, net income is $120,000 and the cap rate is 6.0%.

The gap between the two is the operating expense burden. On net-leased industrial where the tenant pays all outgoings, gross yield and cap rate can be almost identical. On gross-leased office where the landlord bears significant outgoings, the gap can be wide.

So compare like with like. A 7% gross yield on a property with heavy landlord outgoings can equate to a cap rate well below a 6% gross yield on a net-leased asset where the tenant pays every expense.

6 Cap Rate Compression

Cap rate compression is what happens when cap rates fall over time, meaning the market will pay a higher price for the same level of net income. It is one of the main ways commercial property investors book capital growth.

Buy at a 6.5% cap rate, and if the market cap rate for comparable assets later compresses to 5.5%, your property is worth materially more even though the net income has not changed. Taking the earlier $120,000 of net income:

• At a 6.5% cap rate: Implied value = $120,000 / 0.065 = $1,846,154
• At a 5.5% cap rate: Implied value = $120,000 / 0.055 = $2,181,818

That is a gain of roughly $335,000, about 18%, driven entirely by cap rate compression with no change in the underlying income.

Compression can come from falling interest rates, stronger investor demand for a sector, improvements to the asset (such as securing a longer lease or a stronger tenant), or broader economic factors that lower the perceived risk of commercial property.

Cap rate expansion runs the other way and erodes capital values. That is why rising interest rate environments can put downward pressure on commercial property values even when rental income holds steady.

7 Using Cap Rates to Compare Properties

One of the cap rate's most practical uses is ranking the relative value of different investment opportunities. Reduce each property's income and price to a single percentage and you can quickly gauge whether one asset offers better risk-adjusted value than another.

Meaningful comparison, though, means adjusting for the factors that drive cap rates in the first place. Two properties on the same cap rate can carry very different risk if one has a ten-year lease to a listed tenant and the other a two-year lease to a sole trader. A higher cap rate is not automatically better value either; it may simply reflect higher risk.

When you compare properties on cap rate, ask:

• Are the net income figures worked out consistently, with all landlord outgoings deducted?
• Is the passing rent at, above or below market? An inflated rent produces an artificially high cap rate that may not be sustainable.
• What are the remaining lease terms and tenant quality for each asset?
• Are the properties in comparable locations with similar demand and supply dynamics?

8 Limitations of Cap Rates

The cap rate is a valuable tool, but it carries real limitations you have to keep in front of you.

• It ignores capital growth. The cap rate is a snapshot of the income return at a single point in time. It says nothing about a property's potential for capital appreciation, which for many investors is a large part of total return. A property on a 5% cap rate in a high-growth corridor can deliver a far better total return over ten years than one on a 7% cap rate in a stagnating market.
• It ignores vacancy risk. The cap rate assumes the property is fully leased at the current rent. It does not price in the probability or cost of vacancy, particularly for assets with short remaining lease terms or single-tenant exposure.
• It ignores capital expenditure. A property can show a strong cap rate today and still need significant works soon: roof replacement, facade repairs, essential services upgrades, or a refurbishment to attract a new tenant. None of that shows up in the calculation.
• It is only as good as the income figure. Understate the outgoings, omit the vacancy allowance, or use a passing rent above market, and the resulting cap rate will overstate the true return.
• It is a point-in-time measure. Cap rates reflect current market conditions and sentiment. They can shift quickly on interest rate changes, economic events or swings in investor appetite, so a cap rate that looks attractive today may not stay that way.

A cap rate is a good place to start on a commercial property and a poor place to finish. Read it alongside income growth potential, capital expenditure requirements, lease risk and the broader market outlook, never on its own.

How Bold Uses Cap Rates

In our acquisition process the cap rate is one input among many. We use it to screen opportunities, benchmark pricing against comparable sales, and test whether the market is pricing risk sensibly for a given asset. We always look past the headline number to the quality and durability of the underlying income, the capital expenditure profile of the building, and the growth dynamics of the market.

If you are weighing up a commercial property investment and want to know what the cap rate is really telling you about the opportunity, talk to us. We will help you assess the asset thoroughly and decide with the full picture in front of you.