Cap rate
Cap rate (capitalisation rate) is the ratio between a property's stabilised net operating income and the property's sales price or market value. In the income approach, direct capitalisation estimates value by dividing NOI by an appropriate cap rate when the income stream is expected to be stable. Federal Reserve Bank of New York staff research expresses the same perpetuity relationship: property value equals NOI divided by the assumed cap rate based on the income stream's risk.
Cap rate on bank CRE desks
CRE credit desks use cap rates when reviewing appraisals, marking collateral and stress-testing refinance outcomes. OCC's CRE handbook notes that changing capitalisation rates affect property value, and that rising interest rates may lead to higher capitalisation rates and lower property values even when property fundamentals are unchanged. Desks therefore read cap-rate assumptions against property type, location, lease profile and market evidence, then translate value changes into LTV, debt service coverage ratio (DSCR) and debt yield outcomes. For assets still under a construction loan, as-stabilised value depends on the exit cap rate applied to projected stabilised NOI.
Mechanics of direct capitalisation
Direct capitalisation:
- takes stabilised NOI as the income input
- divides that NOI by the selected capitalisation rate
- produces an estimate of market value appropriate when future income is expected to be stable
Where occupancy is not yet stable, or income is expected to fluctuate materially, appraisal practice points to discounted cash-flow analysis rather than a single-period cap rate: future NOI over a holding period plus expected net sale proceeds are discounted to present value. Cap rate and discount rate selection remain judgmental inputs that must match market participant expectations rather than opportunistic or temporary pricing.
Cap rate versus debt yield
Cap rate is an unlevered property yield on value. Debt yield is NOI divided by loan amount. NY Fed staff research states the identity directly: debt yield equals cap rate divided by LTV, so that a debt yield below the prevailing cap rate implies LTV above 100 percent on an income-capitalisation basis. Cap-rate expansion therefore reduces value and raises LTV for a fixed loan, while also changing the debt-yield cushion relative to market yields. Desks separate the market pricing signal (cap rate) from the lender leverage test (debt yield) when documenting refinance risk and collateral margin.