Capitalisation rate

The required annual return used to convert an income stream into a price, most commonly in property. Value is net operating income divided by the rate.

Example

Net operating income of 48,000 at a 6% capitalisation rate gives a value of 800,000.

Important

It is a judgement, not a market fact you look up, and it performs exactly the job a discount rate performs. Moving it from 5% to 9% cut one property's value by 44.4% on an income that never changed.

Related terms

• Net operating income — Rent or trading income after every cost of running the asset except financing - management, maintenance, insurance, tax and an allowance for periods standing empty.
• Gordon growth model — The relationship that values a growing perpetual income stream as next year's income divided by the required return less the growth rate. The same formula produces a terminal value and a capitalisation rate.
• Discount rate — The annual rate at which future money is reduced to a present value, reflecting both the time you wait and the risk that the money does not arrive.

Lessons that explain it

• Gross yield is not a yield — Rent divided by price is the number every listing quotes and no owner receives. Take the five deductions out and Property P's 8.00% becomes 4.264% - and the two halves of the return turn out to be far less connected than they sound. (12 min)
• No closing bell: comparables, appraisal and the cap rate — Nothing quotes this asset. Its price comes from three negotiated sales that happened months ago, adjusted by somebody's judgement - and from an income lens that is more honest and much less popular. (11 min)
• Appraising one property: the numbers, the condition, the tenant and the exit — Seven checks on one specific building. The two that decide most outcomes - the deduction list and whether the income covers the borrowing - are the two that never appear in a listing. (14 min)
• Yield-based valuation: pricing the income — Start from the money the asset actually pays out and the return you require, and the price falls out of the division. The simplicity is real, and it conceals the same growth assumption everything else makes. (11 min)

All 578 terms in the Investing glossary