Cap Rate

What is cap rate in real estate?

Capitalization rate, almost always called cap rate, is the ratio of a commercial property's annual Net Operating Income (NOI) to its purchase price, expressed as a percentage. It's the primary metric investors use to compare income-producing properties and to estimate market value. The formula:

` Cap Rate = Net Operating Income / Property Value × 100 `

NOI is gross rental income minus operating expenses (property tax, insurance, maintenance, management, utilities paid by landlord) but before mortgage payments and income tax. The exclusion of mortgage payments is critical — cap rate measures the property's intrinsic earning power, independent of how it's financed.

How cap rate is used

Investors use cap rate three ways:

1. Comparing properties: a 6% cap rate building in Mississauga and a 5% cap rate building in downtown Toronto are roughly comparable — the Mississauga property generates more income per dollar invested, but the Toronto property is in a market where appreciation typically offsets the lower yield.
2. Estimating value: if comparable properties in the area trade at a 5.5% cap rate and the target property has $120,000 NOI, the implied value is $120,000 / 5.5% = $2,181,818.
3. Setting offer prices: investors plug their target cap rate into NOI to determine the maximum they'll pay.

Cap rate ranges in Ontario

Approximate cap rate ranges for healthy properties (2024-2025 market):

A property with a cap rate well above the market range is typically signaling something: deferred maintenance, environmental issues, lease expirations, or tenant credit problems. Always investigate why a cap rate is high.

Where this appears in your Humber program

Cap rate is foundational in Course 4: Commercial Real Estate in the income-property valuation module, and it returns in continuing-education courses on commercial leasing and investment analysis. Course 4 also tests the related DCR (Debt Coverage Ratio) which is the commercial analog to residential GDS/TDS calculations.

A scenario the exam likes to test

A 12-unit residential apartment building has gross rental income of $240,000/year. Operating expenses (property tax, insurance, maintenance, utilities, professional management at 5%) total $84,000/year. The asking price is $2.6 million.

` NOI = $240,000 - $84,000 = $156,000 Cap Rate = $156,000 / $2,600,000 = 6.0% `

Comparable apartment buildings in the same submarket trade at 5.5%. The exam typically asks one of three questions: 1. What is the implied market value at the comparable cap rate? $156,000 / 5.5% = $2,836,364 — meaning the asking price is at a discount. 2. Is this property a good investment? Above-market cap rate suggests yes, if the NOI is real and not inflated, and if there's no underlying defect. 3. What price should an investor offer to achieve a 6.5% cap rate? $156,000 / 6.5% = $2,400,000.

Cap rate vs cash-on-cash return

The exam tests the distinction. Cap rate ignores financing; cash-on-cash return measures the leveraged return on the actual cash invested. A property with a 6% cap rate and 75% mortgage financing might have a 12%+ cash-on-cash return because mortgage leverage amplifies the return on equity. Investors making decisions about a specific deal usually care more about cash-on-cash; investors comparing markets care more about cap rate.

Frequently asked questions

What is a good cap rate in Ontario?

There's no universal "good" cap rate — it depends on property type and market. As of 2024-2025: Toronto Class-A office is 4.5-5.5%; suburban industrial is 5-6%; multi-residential is 4-5% in Toronto and 5.5-6.5% in secondary markets. A cap rate well above the market typical (e.g., 9% for an apartment building) usually signals risk: deferred maintenance, weak tenants, or location issues. A cap rate below market (e.g., 3% in a stable submarket) may signal aggressive pricing or strong appreciation expectations.

Does cap rate include mortgage payments?

No. Cap rate uses Net Operating Income which excludes mortgage payments and income tax. This is intentional — it lets investors compare properties independent of how each one is financed. Cash-on-cash return is the related metric that does incorporate mortgage payments.

How do you calculate NOI for cap rate purposes?

NOI = Gross rental income − Vacancy allowance − Operating expenses. Operating expenses include property tax, insurance, repairs and maintenance, professional management fees, utilities paid by landlord, and (for commercial) common-area maintenance. NOI excludes mortgage payments, capital expenditures, depreciation, and income tax. The clean separation between operating costs and financing/capital costs is what makes NOI comparable across properties.

Why do cap rates differ between cities?

Cap rates reflect both risk and growth expectations. Lower cap rates (Toronto, Vancouver) signal investors expect strong appreciation and stable tenancies, so they accept lower current yield. Higher cap rates (smaller cities, secondary markets) signal investors require more current yield to compensate for slower appreciation or weaker tenant pools. The relationship is inverse: as a market becomes more desirable, cap rates compress (fall) and prices rise.

Practice this topic

ExamAce covers cap rate calculations and commercial valuation in Course 4 practice questions with scenario problems modeled on the Humber commercial-real-estate exam format. For the broader finance picture across residential and commercial, see the real estate finance pillar guide.