How do you calculate a cap rate?

Divide a property's net operating income for a year by its price or value. A building that earns US$500,000 after operating costs and sold for US$8.0m has a cap rate of 6.25%. To value a building, reverse it: divide its income by a cap rate taken from comparable sales. Income means net of owner's costs but before interest and tax, so that the figure says something about the property and not about how it is financed.

Is a higher cap rate better or worse?

It depends on where you are standing. A buyer gets more income for each dollar paid at a higher rate, but the rate is usually high because the income is seen as riskier or less likely to grow. An owner who sees the rate rise on its building has lost value. A lender holding a loan against it sees LVR rise. There is no good level in the abstract: the rate has to be read against the lease, the tenant, the location and the rates on similar buildings.

How do interest rates affect cap rates?

They push in the same direction, though not one for one and not immediately. When government bond yields and borrowing costs rise, buyers want a higher return from property and can borrow less to pay for it, so prices tend to soften and yields rise. The margin between yields and bonds can absorb part of the move for a time. Valuations also lag, since valuers depend on completed sales and those become scarce as buyers and sellers disagree on price.

What is the difference between a cap rate and a yield?

In everyday use the two are often the same figure. Strictly, yield is a family of measures. An initial yield uses the rent passing today; a reversionary yield uses the market rent expected once leases reset; an equivalent yield blends them; and in the UK a net initial yield also counts the buyer's purchase costs in the price. Before comparing two numbers, a lender asks which income and which price each one used.

// WORKED EXAMPLETHE ARITHMETIC A DECISION RESTS ON

Capitalisation Rate: a Worked Example

The tenants paid on time. The loan-to-value rose ten points.

BY MICHAEL SHANG · SIXTEEN YEARS IN COMMERCIAL BANKING · UPDATED 2026-11-09 · 6 MIN READ

// THE SHORT ANSWER

A capitalisation rate is how a valuer turns one year of a property's income into a price, and the reason a lender can find its security worth less though every tenant has paid. It is read from recent sales of similar buildings, as income divided by price, and applied to the building being valued. The bank's debt stays fixed while that market figure moves, so the loan-to-value moves too. A property lender therefore looks past the valuation's total to its two inputs, and asks what the value becomes if buyers want a higher return.

BASIS Practitioner judgment from sixteen years in commercial banking, set out in How Bankers Think (Highbank Press, 2026). Every borrower on this site is a composite constructed for teaching, not a client. The market is mid-market commercial lending as practised in New Zealand and Australia; where a convention differs elsewhere, the page says so.

// MAKE THE CALL

Issue 08 — Basalt Ridge Developments. A new-to-bank developer, a claimed 28% ROE and two other banks circling. Your bank has a growth target. Your call first, then the senior banker's.

Read the file →

PART OF Property Development Finance

// 01 — WHY A LENDER READS THE RATE, NOT JUST THE VALUE

A valuation of an income-producing property arrives as one number. Inside it are two claims: what the building earns, and what return a buyer would accept for that income. The first can be checked against a rent roll and a set of leases. The second is a reading of the market on a given day, taken from what other people recently paid, and it can change without any event at the building.

A higher rate means a lower price for the same income. The rate is higher where the income is less secure or the buyer expects less growth: a short lease, a weak tenant, a secondary location, an old building. The Reserve Bank of Australia, reviewing commercial property in 2023, noted that such assets are valued by discounting expected income, which is why higher interest rates reach valuations. They reach them slowly, because valuers need sales to work from and sales thin out when prices are moving.

// 02 — HOW THE RATE IS DERIVED AND APPLIED

Cap rate from a sale = net operating income ÷ sale price

Value of the subject = net operating income ÷ chosen cap rate

LVR = loan ÷ value

= cap rate ÷ debt yield

Net operating income is rent less the costs the owner bears, after a vacancy allowance where one is warranted and before interest and tax. A valuer rarely capitalises the passing rent and stops. The income is usually brought to a market level, with separate adjustments for rent above or below market, incentives still running, letting-up periods and capital works due.

Vocabulary and conventions differ. New Zealand and Australian valuers usually speak of a capitalisation rate or market yield. UK valuers more often speak of an all-risks yield, or of a net initial yield, which divides the income by the price plus the buyer's costs, stamp duty land tax or its Scottish or Welsh counterpart among them. Australian stamp duty varies by state, and New Zealand has none. Two buildings quoted at the same yield in different markets may therefore not be priced the same.

The rate is a single-year shortcut for a longer calculation. Roughly, it is the return a buyer requires less the income growth it expects, which is why a rise in required returns and a fall in expected rents push the rate the same way. A discounted cash flow, which a valuer may run beside it, sets out those years individually.

// 03 — THE EXAMPLE

A bulky-goods retail park, constructed for this page like every figure in it, earns net operating income of US$2.40m. It was valued at a 6.0% cap rate and carries a loan of US$24.0m. The agreement sets a maximum LVR of 65%. That limit and all these rates are the example's, not market levels.

Income Cap rate Value (US$m) LVR

2.40 6.00% 2.40 ÷ 6.00% = 40.00 60.0%

2.40 6.50% 2.40 ÷ 6.50% = 36.92 65.0% ← at the limit

2.40 7.00% 2.40 ÷ 7.00% = 34.29 70.0%

2.16 6.00% 2.16 ÷ 6.00% = 36.00 66.7% ← income down 10%

2.16 7.00% 2.16 ÷ 7.00% = 30.86 77.8% ← both

Debt yield throughout the first three lines: 2.40 ÷ 24.0 = 10.0%

Refinance at 60% of the value at 7.00%: 34.29 × 60% = 20.57

Gap to the existing loan: 24.00 − 20.57 = 3.43

Half a point of yield uses all of the headroom, and no tenant has left. A full point takes US$5.71m off the value and adds ten points to the LVR. The last row is the one a lender worries about, because a weakening market tends to raise yields and lower rents together. The bottom lines show where the damage lands if the loan comes up for renewal: a new lender holding to the same 60% provides US$3.43m less than is owed, and that gap has to come from the owner.

Low rates are also more sensitive than high ones. A move from 4% to 5% cuts value by 20%; a move from 8% to 9% cuts it by about 11%. The same one-point shift does more harm to a tightly priced building.

// 04 — THE RATIOS A LENDER READS BESIDE IT

The formula above shows why debt yield exists. It divides income by the loan and leaves the cap rate out, so it does not move when the market does. In the example it held at 10% while the LVR ran from 60% to 70%. Interest cover also ignores the cap rate, though it moves with the loan's cost, which often rises in the same conditions that raise yields.

A lender therefore reads three things that can disagree: LVR, which carries the market's opinion; debt yield, which carries the building's income; and interest cover, which carries the rate. A building can pass cover comfortably and still fail on value. The Reserve Bank of Australia warned in 2023 that lower valuations and tighter lending standards could leave more borrowers with a funding gap at refinancing.

DEFINED IN ONE PARAGRAPH → · DEBT YIELD → · NET OPERATING INCOME →

// 05 — WHERE IT DECIDES A FILE

At origination, the lender sizes the loan on the valuer's rate and then tests a higher one. How much higher is its own policy. It also checks whether the comparable sales are close in time, place, lease length and tenant quality, and whether a rate from a prime building has found its way into a secondary one.

During the loan, the rate is often invisible. An LVR covenant is only as current as the last valuation, and an agreement may let the lender call for a new one only on a schedule or a trigger. Between valuations, the LVR on the compliance certificate can be a figure from a market that has gone. A lender watching yields in sales evidence can estimate the movement and raise it before the formal valuation does, and it looks hardest at over-rented buildings in its book, where the income is likely to reset as well as the rate. The clause that sets the valuation timing differs from deal to deal and is worth reading first.

LVR, SECURITY AND COLLATERAL → · VACANCY ALLOWANCE →

// SOURCES

The documents the statements on this page rest on. Each was opened and checked when cited.

Reserve Bank of Australia, Bulletin, September 2023, Financial Stability Risks from Commercial Real Estate — States that commercial property is valued by discounting expected income, that valuation discount rates lagged higher interest rates, and that more borrowers could face a funding gap on refinancing — sections 01 and 04.

// QUESTIONS PEOPLE ASK

How do you calculate a cap rate?: Divide a property's net operating income for a year by its price or value. A building that earns US$500,000 after operating costs and sold for US$8.0m has a cap rate of 6.25%. To value a building, reverse it: divide its income by a cap rate taken from comparable sales. Income means net of owner's costs but before interest and tax, so that the figure says something about the property and not about how it is financed.
Is a higher cap rate better or worse?: It depends on where you are standing. A buyer gets more income for each dollar paid at a higher rate, but the rate is usually high because the income is seen as riskier or less likely to grow. An owner who sees the rate rise on its building has lost value. A lender holding a loan against it sees LVR rise. There is no good level in the abstract: the rate has to be read against the lease, the tenant, the location and the rates on similar buildings.
How do interest rates affect cap rates?: They push in the same direction, though not one for one and not immediately. When government bond yields and borrowing costs rise, buyers want a higher return from property and can borrow less to pay for it, so prices tend to soften and yields rise. The margin between yields and bonds can absorb part of the move for a time. Valuations also lag, since valuers depend on completed sales and those become scarce as buyers and sellers disagree on price.
What is the difference between a cap rate and a yield?: In everyday use the two are often the same figure. Strictly, yield is a family of measures. An initial yield uses the rent passing today; a reversionary yield uses the market rent expected once leases reset; an equivalent yield blends them; and in the UK a net initial yield also counts the buyer's purchase costs in the price. Before comparing two numbers, a lender asks which income and which price each one used.

// NEXT TO IT

// ON WHOSE DESK

The seats that read this term in an ordinary week. Each page says what the seat is for, who arrives in it, and the shape of the round it runs.

Credit analystReads a borrower and writes the recommendation a decision-maker will act on.
Credit sanctionerHolds delegated authority and signs — or declines — the lending the front line brings.
Workout and recoveries managerTakes the files that have gone wrong and works out how much the bank gets back, and how.

THE IN-TRAY · ONE MINUTE

Make the call on one file.

A short file on the ground this page covers. Every option opens with how far it sits from a senior banker’s read.

THE NUMBER · THE ECONOMY · COLLATERAL MARKETS

An office building earns US$1.0m a year of net operating income. Buyers price such buildings at a 5% yield, so it is valued at US$20m. The loan against it is US$12m.

If the yield buyers want rises to 6%, what is the loan-to-value?

3 MORE ON THE ECONOMY · COLLATERAL MARKETS →WHERE DO YOU READ FROM? THE PLACEMENT →

THE READING ROOMIN ONE PARAGRAPHCapitalisation rate (cap rate) What is a capitalisation rate, and why does it move a property's loan-to-value?