Written byA cap rate is either a ceiling written into a variable interest rate, or, in property, short for capitalisation rate: net operating income divided by value.
Also known as: capped rate, rate cap, capitalisation rate
Key points
- A capped variable rate can still fall if the market falls, but it cannot rise past the cap while the cap applies.
- In property investing the same two words mean capitalisation rate: annual net operating income divided by the property's value.
- A cap limits interest rate risk without locking you in, so lenders usually charge a fee or a wider margin for it.
- Caps normally run for a set period, after which the loan reverts to the lender's ordinary variable rate.
How a rate cap works
A capped rate sits on top of a variable loan. The rate can move up and down with the market like any variable loan, but the contract sets a maximum it cannot pass. If the underlying rate climbs above the cap, you keep paying the cap. If it drops, you get the benefit of the fall.
The lender is carrying that risk, so it prices for it, usually through a fee or a slightly wider margin than a plain variable loan. The mirror image is a floor rate, a minimum the rate cannot fall below, and a contract can carry one, both or neither. Against a fixed rate, a cap keeps the upside of falling interest rates while limiting the damage from rising ones. Against a plain variable loan, it costs more in the periods when nothing much happens.
Cap rate in property investing
The same two words mean something else in property. There, cap rate is short for capitalisation rate, and it measures the return a building produces: annual net operating income divided by the purchase price or current value. Net operating income is rent after outgoings such as council rates, insurance and management, but before finance costs and tax.
Investors use it to compare properties quickly. A higher cap rate generally signals a higher return and higher perceived risk; a lower one signals the opposite. It says nothing about how the purchase is funded, so it is read next to the loan to value ratio and the cost of the home loan or commercial facility behind it.
When a rate cap is worth it
Capped loans suit borrowers who want protection but think rates may ease, or who need certainty about the worst case without giving up the chance of a fall. Businesses with tight cashflow sometimes use one to put a known ceiling on repayments while a contract runs.
The things to compare are the level of the cap, how long it lasts, what the loan reverts to afterwards, and what the protection costs in fees or margin. A broker can line those up across lenders, and your accountant can explain how the cost is treated for tax.
Example
A civil contractor finances a $250,000 grader on a variable facility with a two year cap. Market rates rise sharply in the first year, but the repayments stop climbing once the cap is reached, which keeps the job costings the business quoted from being blown apart. In the second year rates ease and the repayments fall again, because the cap is a ceiling, not a fixed rate. At the end of the two years the facility reverts to the lender's ordinary variable rate.
Not to be confused with
- Fixed rate
- a fixed rate locks the rate in both directions, while a cap only limits how high it can go
- Variable rate
- a capped loan is a variable loan with a ceiling written into the contract
- Floor rate
- a floor sets the minimum rate the contract allows, while a cap sets the maximum
Frequently asked questions
What does cap rate mean?
In lending it means the highest interest rate you can be charged on a variable loan for an agreed period. In property investing it means capitalisation rate, a measure of return. The context tells you which one someone is using, so it is worth checking.
How is a cap rate calculated in property?
Divide the property's annual net operating income by its price or current value, then express the result as a percentage. Net operating income is the rent left after outgoings such as council rates, insurance, repairs and management, but before loan repayments and tax.
Is a capped rate better than a fixed rate?
It depends on what you want. A fixed rate gives you one known repayment and no benefit if rates fall. A cap protects you from the worst case but lets you enjoy a fall. Caps usually cost more than a plain variable loan, so weigh the protection against the price.
What happens when the cap period ends?
The loan normally reverts to the lender's standard variable rate, with no ceiling. That reversion is worth reading before you sign, because the rate can then move freely. Some borrowers refinance or fix at that point rather than sit on the revert rate.
What is a good cap rate for a property?
There is no single answer. Cap rates vary by asset class, location, lease quality and the length of the lease, and they move with the market. A high cap rate often reflects higher risk rather than a bargain. Compare like with like and take advice on the specific property.
Related terms
Variable rate
A variable rate is an interest rate that can move up or down over the life of a loan, following the lender's benchmark and its margin.
Read definitionFixed rate
A fixed rate is an interest rate locked in for a set term, so the rate and usually the repayments do not change until that term ends.
Read definitionInterest rate risk
Interest rate risk is the exposure a financial asset, liability or portfolio has to changes in market interest rates, which alter the present value of its future cash flows.
Read definitionRate
A rate is a ratio or charge expressed against a unit, commonly per year, that measures cost, return or proportion; in finance it usually means an interest rate.
Read definitionComparison rate
A comparison rate is a single annual percentage that combines a loan's interest rate with most upfront and ongoing fees to show its ongoing cost more clearly.
Read definitionFloor rate
A floor rate is the minimum interest rate a variable loan contract allows; lenders also use the phrase for the minimum rate they test serviceability against.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.