Just as stocks have the P/E ratio, real estate has its own quick yardstick: the cap rate. Learn this one ratio and a lot of property talk makes sense.
The cap rate
The capitalisation rate (cap rate) is a property’s income yield:
Cap rate = net operating income (NOI) ÷ property price
Net operating income is the annual rent left after running costs (but before any mortgage). A building earning $50,000 NOI that costs $1,000,000 has a 5% cap rate — it yields 5% a year on the purchase price, ignoring financing.
It’s the property world’s equivalent of an earnings yield, and it lets you compare very different buildings on one number.
What a cap rate signals
- A high cap rate means a higher income yield — often a riskier property, weaker location, or shakier tenants (you’re paid more to take on more).
- A low cap rate means a lower yield — usually a prime, safe, in-demand property (people accept less income for quality and security).
Cap rates also move with interest rates: when safe bond yields rise, investors demand higher cap rates too (lower prices), and vice versa — the link the next lesson explores.
Cap rate vs price
Here’s the useful flip: price = NOI ÷ cap rate. If a building earns $50,000 and similar properties trade at a 5% cap rate, it’s worth about $1,000,000. Raise the rent (NOI) or compress the cap rate (lower yields) and the value rises. (REIT investors use a related idea, valuing the portfolio’s net assets and its FFO.)
Worked example
A small apartment block is on the market for $1,200,000. It collects $96,000 a year in rent, and running costs (management, maintenance, insurance, property tax — not the mortgage) come to $30,000.
NOI = $96,000 − $30,000 = $66,000 Cap rate = NOI ÷ price = $66,000 ÷ $1,200,000 = 5.5%
Now compare it to a similar building down the road priced at a 6.5% cap rate. The rival offers more income per dollar — so either this block is overpriced, or the market sees it as safer (better location or tenants). To match a 6.5% cap rate, this block’s price would have to fall to $66,000 ÷ 0.065 ≈ $1,015,000. That’s the cap rate doing its job: turning very different buildings into one comparable yield.
The takeaway
The cap rate — net operating income ÷ price — is real estate’s income-yield yardstick. High cap rate = more yield but usually more risk; low = prime and safe. And price = NOI ÷ cap rate, so rents and prevailing yields drive value. (This is education, not investment advice.)