Capitalisation Rates Explained Simply

What is a capitalisation rate?

A capitalisation rate — or cap rate for short — is a way to measure the return you’ll get from a commercial property, based purely on the rental income it generates.

Think of it as the income yield on a property — similar to how you might look at dividend yield when buying shares.

The cap rate formula is simple:

Cap Rate = Net Annual Rent ÷ Purchase Price

So, let’s say you’re looking at a property that brings in $100,000 per year in rental income (after expenses like maintenance and management), and it’s selling for $2 million. That gives you a cap rate of 5 per cent.

Cap rates help you compare different investment options on equal footing, whether it’s a shopping centre, warehouse or office building — and they give you a quick way to gauge value, risk and potential return.

How cap rates compare to other investments

Cap rates might sound like a real estate-specific concept, but they’re really just one version of a broader idea — what am I getting back for the money I put in?

Here’s how cap rates stack up against familiar types of investments:

While residential property often focuses on capital growth and emotional appeal, commercial real estate is more income-driven — which is why cap rates are such an important metric.

What causes cap rates to rise or fall?

Cap rates aren’t fixed — they change depending on market conditions, investor sentiment, and broader economic forces.

Here’s how it generally works:

• When interest rates are low and buyer demand is strong, investors are often happy to accept lower returns, which pushes cap rates down. That drives property values up.

• When uncertainty rises — such as during economic slowdowns or rate hikes — investors become more cautious and demand higher returns. This pushes cap rates up, and values tend to fall.

Cap rates are also influenced by location, lease terms and tenant quality. A warehouse leased to Woolworths for 10 years in a growth corridor might sell at a lower cap rate (higher price), because it’s seen as lower risk. An office in a less desirable area with a short lease might need a higher cap rate to attract buyers.

In other words, cap rates reflect the balance between perceived risk and expected return — just like yields in the stock or bond market.

Why timing matters so much

If you understand how cap rates work, you can start to see the cycles in the market — and how to position yourself ahead of them.

Imagine a property market where prices barely move for years, then suddenly surge over a short 4–5 year window.

Investors who understand how cap rate compression works (when yields tighten and values rise) might spot the early signs:

• Cap rates starting to fall below their long-term average
• Buyer competition increasing for well-leased assets
• Rents beginning to rise but sale prices rising faster
• Demand from institutions or overseas capital heating up

These are all clues that the market’s heating, and that capital is flowing in faster than supply can keep up. By recognising this shift early, savvy investors can time their exit — often before peak prices hit — and lock in strong returns.

Those who miss those signs? They might hold too long, watch potential gains shrink and in some cases be forced sell in a weaker market when rising cap rates pull property values down.

Understanding cap rates doesn’t guarantee you’ll pick the top or bottom of a cycle. But it gives you a massive edge in knowing when it’s time to move.

Cap rates aren’t everything — but they’re a powerful starting point

A cap rate tells you the income return on the property today, but it doesn’t tell you everything.

It doesn’t include:

• Future rental growth
• Changes in tenant risk
• Development or value-add potential
• Tax considerations or financing
• Market supply and demand shifts

So while cap rates are useful, they’re only one piece of the puzzle. Think of them as a filter, a way to sort through properties quickly and identify which deals are worth digging into.

They won’t tell you if something’s a great investment on their own, but they’ll help you ask the right questions faster.

Why we talk about this

At Properties & Pathways, we’ve helped hundreds of investors build wealth through commercial and residential property. And we’ve seen firsthand how much better your outcomes can be when you better understand the tools, benchmarks and measurements the experts use.

Cap rates aren’t complicated, but they’re often misunderstood. Once you know how they work, you start to see the market more clearly. You start spotting opportunities others miss, and you make decisions that aren’t based on hype or headlines — but actual data.

Want more insights like this?

Every month, we break down commercial property concepts like this in our newsletter. It’s enjoyed by hundreds of commercial and residential property investors, both those who are sophisticated and those who are just starting out.

Whichever side of the coin you fall on, understanding key concepts like cap rates can help you invest with more confidence, less noise and better timing.

Subscribe to our newsletter and get our expert insights delivered straight to your inbox. Every piece of content is free, and you can unsubscribe anytime.