How to calculate cap rates (and use them properly)

For seasoned commercial property investors, the capitalisation rate—or cap rate—is one of the most reliable tools for evaluating the potential return of a property. It’s one of the most frequently talked about measurements in our office and undoubtedly within the four walls of every commercial property investment group across the nation.

Why? Because whether you’re weighing up one or more potential purchases or reviewing your portfolio’s performance, cap rates help you assess an asset’s value based on arguably its most important feature: income.

Cap rates are simple to calculate—more simple than most assume. But interpreting them properly is where experience comes in.

In this post, we’ll walk through:

• What cap rates are
• Why they matter in commercial real estate
• How to calculate them quickly
• What a “good” cap rate actually looks like
• And how to interpret them in context

Best of all, we’ve built a free cap rate calculator you can use below. It shouldn’t be relied upon as part of your due diligence but is a great tool to better understand cap rates (and of course the value of your or your prospective property).

What is a cap rate?

A cap rate is a snapshot of a property’s return, expressed as a percentage. It tells you how much income a property is generating relative to its price—and it assumes you’ve bought the property outright (without debt).

The formula looks like this:

Cap rate = Net operating income (NOI) ÷ Purchase price

As an example, if a property earns $120,000 in annual net income and is purchased for $2 million, the cap rate is:

$120,000 ÷ $2,000,000 = 6%

It’s a simple ratio—but like all tools, its value lies in how you use it.

Why experienced investors rely on cap rates

Cap rates help you:

• Compare properties based on income yield
• Track how yields are changing across asset classes and locations
• Spot when markets are overheating
• Understand investor sentiment and risk appetite (by watching the trajectory of cap rates)

At P&P, we’ve used cap rate trends for more than a decade to inform acquisition and exit decisions across office, industrial and retail. When cap rates are falling, values are often rising—driven by demand, low interest rates or future upside.

And when cap rates are rising? We pay close attention. That’s often a signal of weakening fundamentals or risk repricing.

Use the calculator above to run your own cap rate scenarios. Input your net operating income and purchase price—and get an instant cap rate.

Cap rates are just the start

Cap rates give you a return measure at a point in time. But they don’t account for growth, debt or capex.

That’s why we use cap rates as just one of several tools during our due diligence investigation, alongside:

• IRR (internal rate of return) to factor in cash flow over time
• Debt coverage ratios (and interest coverage ratios) to assess our potential serviceability
• Lease terms and expiries to understand current and future risk and upside

Still, cap rates are very powerful for gauging where a property sits in the market. For example:

• High cap rates (e.g. 7–9 per cent) could mean higher risk or weaker demand
• Low cap rates (e.g. 4–5 per cent) usually signals prime location, long leases or strong tenant covenants

As you can guess, context is key. A 7 per cent cap rate on an industrial asset with limited competition and future rent uplift might be far more attractive than a 5 per cent cap rate in an ageing fringe office.

Understanding how cap rates fit within the context of a particular purchase or market is a skill that can completely alter your investment decisions.

What is a “good” cap rate?

There’s no universal answer to this, and you should beware anyone who claims there is.

Cap rates vary by:

• Asset type (office, retail, industrial, medical)
• Location (CBD, metro, regional)
• Lease structure and term
• Market conditions (interest rates, economic outlook, supply pipeline)

In some markets, a 5 per cent cap rate is attractive. In others, that might be overpriced. The real question is whether the return reflects the risk, and whether the assumptions driving the suggested income are realistic.

Cap rates won’t give you every answer

But they will help you ask the right questions. And for commercial investors, where data is crucial to investment decisions, that’s half the battle.

We built our free calculator to make that easier. Use it as a tool—not as your north star—and let it prompt you for deeper investigation into your asset or your prospective acquisition.

Want more commercial property insights like this?

Join our monthly newsletter. Every article is free, always relevant and read by hundreds of sophisticated investors across Australia. You can unsubscribe any time—and we never spam.