A cap rate is only high or low against the return you need and the growth and capex the building comes with, and the arithmetic takes three lines.
There is no universally good cap rate: a cap rate is good when it exceeds the one your required return implies. Take the return you need, subtract long-run NOI growth, and gross up for capital expenditure: with an illustrative 7.50 per cent required return, 2.00 per cent growth and capex at 8 per cent of NOI, the break-even cap rate is (7.50% − 2.00%) ÷ 0.92 = 5.98 per cent. Buy above it and the deal clears; below it and you are paying for growth you have not underwritten.
Worked in full in Real Estate Fund Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The question is usually asked as if cap rates had a correct level, the way a covenant has a threshold. They do not. A 5 per cent cap can be cheap and an 8 per cent cap expensive, because the cap rate is the income yield only, and the return also contains growth and is reduced by the capex the building eats. Separating those three pieces is the whole calculation.
| Input | Value |
|---|---|
| Risk-free rate (illustrative) | 4.25% |
| Property risk premium for this asset | 3.25% |
| Required unlevered return, r | 7.50% |
| Long-run NOI growth, g | 2.00% |
| Recurring capex as a share of NOI | 8% |
| Forward NOI | 1,000,000 |
Every rate in this article, the cap rates included, is illustrative and chosen to show the arithmetic; none is a quote of where any market trades today. The risk premium is the judgement. It should reflect the asset's own quality, tenant credit, lease length and liquidity, not the premium the last deal in the market happened to clear at.
Cap rate on cash flow after capex = r − g
Cap rate on NOI = (r − g) ÷ (1 − capex share)
Implied return at an offered cap ≈ cap × (1 − capex share) + g
In Excel: =(Req_Return-Growth)/(1-Capex_Share). The formula is the constant-growth valuation rearranged, and it assumes you sell at the same cap rate you bought at.
Check it with a DCF. Buy at 16,727,273, collect 920,000 growing at 2.00 per cent for ten years, and sell at the end of year 10 at the same 5.98 per cent on year-11 NOI of 1,218,994, which is 20,390,452. The IRR of that cash flow is exactly 7.50 per cent. If your model does not reproduce the required return under these conditions, the exit or the capex line is wired wrongly.
Run the formula backwards. A vendor quoting a 6.25 per cent cap prices the building at 1,000,000 ÷ 6.25% = 16,000,000, which is 727,273 or 4.3 per cent below the 5.98 per cent value. The implied unlevered return is 6.25% × 0.92 + 2.00% = 7.75 per cent, 25 basis points above the required 7.50. On these assumptions, yes, it is a good cap rate. The same 6.25 per cent on a building with no growth implies 5.75 per cent, below the risk-free rate plus any sensible premium. The cap rate did not change; the deal did.
The formula holds the exit cap equal to the entry cap. If you expect to sell at a higher cap, the headroom shrinks, and the break-even exit yield tells you how far the exit can drift before the required return is lost.
| Profile | r | g | Capex share | Cap rate |
|---|---|---|---|---|
| Long lease, low capex | 7.00% | 1.50% | 3% | 5.67% |
| Base case | 7.50% | 2.00% | 8% | 5.98% |
| Growth-led, short leases | 7.75% | 3.00% | 5% | 5.00% |
| Older asset, heavy capex | 8.50% | 1.00% | 15% | 8.82% |
The growth-led asset needs a higher return than the base case and still justifies the lowest cap rate, 5.00 per cent, because a full point of extra growth outweighs the premium. The older asset justifies 8.82 per cent: a buyer who sees an 8 per cent cap and calls it high is overpaying for it.
| Required return | g 1.00% | g 2.00% | g 3.00% |
|---|---|---|---|
| 6.50% | 5.98% | 4.89% | 3.80% |
| 7.50% | 7.07% | 5.98% | 4.89% |
| 8.50% | 8.15% | 7.07% | 5.98% |
The diagonal repeats because only r minus g matters. Each 100 basis points of growth moves the fair cap by about 109 basis points once capex is taken out, which is why the growth assumption deserves as much scrutiny as the risk premium.
The common mistake is to set the cap rate equal to r minus g on NOI and forget capex. That gives 5.50 per cent, a value of 18,181,818, and an overpayment of 1,454,545, or 8.7 per cent, before anything else goes wrong. The second mistake is quieter: comparing cap rates across assets as if they were returns. A cap rate is a price. The return is the cap after capex plus growth, and two buildings at the same cap can differ by two points of return.
For a development, the same comparison is made with yield on cost against the market cap rate; for listed property, a REIT's implied cap rate gives the market's own number to test against.
Ask what cap rate your return requires, not what cap rate is normal. Here the answer is 5.98 per cent, a 6.25 per cent offer clears it by 25 basis points of return, and the growth and capex lines decide that verdict as much as the cap itself. The free workbooks for this case tie the underwriting score to the yield premium, so the premium has a source.
Only if growth and capex are equal. A higher cap rate means more income per dollar today, but the return is roughly the cap rate after capex plus growth. With capex at 8 per cent of NOI, a 6.25 per cent cap and 2.00 per cent growth implies 7.75 per cent; the same 6.25 per cent with no growth implies only 5.75 per cent.
Expected unlevered return is approximately the cap rate times one minus the capex share, plus long-run NOI growth, assuming you exit at the same cap rate. An illustrative 6.25 per cent cap, 8 per cent capex and 2.00 per cent growth gives 6.25 x 0.92 + 2.00 = 7.75 per cent. A ten-year DCF with a matching exit reproduces the result.
Almost one for one, and slightly more once capex is taken out. With capex at 8 per cent of NOI, every 100 basis points of expected growth moves the fair cap rate by about 109 basis points: at a 7.50 per cent required return, 1.00 per cent growth justifies 7.07 per cent and 3.00 per cent growth 4.89 per cent.
Chapter 8 of Real Estate Fund Management scores an acquisition on a six-criterion rubric that feeds a required yield premium; the free companion workbook makes that link live. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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