What Is a Cap Rate, and What Counts as a Good One

Why it ignores the mortgage on purpose

Two buyers can pay the same price for the same building and get completely different returns on their own money, purely because one borrowed 80 percent and the other paid cash. That difference says something about the buyers, nothing about the building. Removing the financing is what turns the cap rate into a property-level measure: it answers what this asset yields, full stop.

That is also its limit. The cap rate cannot tell you whether you can afford the property, whether the monthly numbers work or what your own money earns — those are the jobs of cash flow and cash-on-cash return. Use the cap rate to choose between assets and the other two to decide whether to buy one at all.

A high cap rate is priced, not found

Cap rates are set by what buyers will pay, and buyers pay less for income they trust less. A high cap rate is therefore the market saying that this income is riskier, harder to maintain or less likely to grow: a shrinking town, a short remaining lease, a single tenant, a building facing a major works bill. The yield is compensation for that risk, not a mispricing you spotted first.

The reverse holds too. A 3 percent cap rate in a large, liquid city is not a bad investment by definition — it is the price of an income stream people expect to be there in twenty years, and of an asset that can be sold quickly. Judge the level against comparable buildings in the same market, never against a national average.

Reading it backwards to value a building

Rearranged, the formula becomes price = net operating income ÷ cap rate, which is how income property is actually valued. If comparable buildings in the area trade at a 5 percent cap rate and yours produces $6,546 of net operating income, it is worth roughly 6,546 ÷ 0.05 = $130,920 to that market, whatever the seller is asking.

This is also why raising rent or cutting a recurring charge is worth far more than the amount itself. At a 5 percent cap rate, permanently removing $500 a year of charges adds 500 ÷ 0.05 = $10,000 of value — twenty times the saving, because the market capitalises the income, not the one-off.

Frequently asked questions

Cap rate or gross yield — which should I use?

Gross yield to filter listings quickly, cap rate to compare the two or three you shortlist. Gross yield ignores charges entirely, so it flatters buildings with high service charges or heavy maintenance — exactly the ones that look cheapest in an advert.

Should I use the asking price or what I actually pay?

Use what you actually pay, including acquisition costs, if you want your own return. Use the market price if you want to compare the building with others on the same basis. State which one you used, because the two can differ by 8 percent of the price and nobody can tell from the result alone.

Does the cap rate change after I buy?

Your own entry cap rate is fixed, because your purchase price never changes. The market cap rate keeps moving with rents and prices, and the gap between the two is exactly how the investment performs: rents rising faster than the market rate is what makes the building worth more than you paid.