Understanding Cap Rates in Commercial Real Estate

A cap rate (short for capitalisation rate) tells you how much income a property generates relative to its price. For example, a property with a 6% cap rate is expected to generate 6% of its purchase price in annual income before financing costs. Think of it as the annual return you'd earn if you paid cash, before factoring in any loans or financing.

In commercial real estate investing, cap rates let you compare properties and gauge whether the income aligns with the price. Once you know how to interpret them, cap rates become a practical tool for spotting value and figuring out whether a property appears overvalued, undervalued, or fairly priced relative to similar assets. Understanding this measure is key to evaluating commercial property for sale.

Cap rates apply across all major commercial asset classes. So, whether you're looking at office buildings for sale or want to buy an apartment building, cap rates are a quick way to benchmark expected return and risk without using complex financial models.

How Do You Calculate a Cap Rate?

Divide the property's annual net operating income by its current market value.

Here's the good news: the calculation is straightforward. Take the property's net operating income (NOI), which is the annual rental income after operating costs, and divide it by the property's market value or purchase price. For reliable comparisons, use the same definition of NOI across all properties so that your results stay accurate and meaningful.

Step 1: Find the Net Operating Income (NOI).

Start with the total rent collected over a year and subtract regular expenses such as property taxes, insurance, maintenance, and management fees. Lease structure also plays a role in net income. Operating costs and terms, including the type of lease, can make a noticeable difference in a property's NOI and overall cap rate.

Mortgage payments and income taxes are excluded because cap rates measure the property's income before financing. One wrong number here could mean overpaying by tens of thousands, so accuracy matters more than speed.

Step 2: Divide NOI by the Property Value.

Take the NOI and divide it by what the property is worth today or what you plan to pay for it. The result is expressed as a percentage.

Example

Let's say a Mississauga commercial property earns $150,000 in NOI and is valued at $2.5 million.

$150,000 ÷ $2,500,000 = 6% cap rate

That property would deliver about a six percent annual return before any financing or tax factors come into play.

Why Do Investors Use Cap Rates?

Cap rates help investors compare the return potential and relative risk of different properties.

Cap rates let you compare properties that look completely different on paper. A $5 million office building and a $1 million retail plaza might both deliver similar returns once you run the numbers. With cap rates, you can distill complex financial details into a single percentage that reflects both risk and reward.

Markets move quickly, and spotting when yields tighten can give you the edge that sets your offer apart. This makes cap rates one of the simplest ways to evaluate how pricing aligns with potential return.

Properties with tenants on long-term leases, such as grocery-anchored retail or medical offices, tend to have lower cap rates. Assets with higher tenant turnover, such as apartment buildings or independent retail spaces, often have higher cap rates.

Rather than chasing a specific number, investors consider property types and markets that can significantly impact cap rates. When borrowing costs are low or confidence is high, cap rates tighten. When uncertainty grows, they expand.

What Is Considered a Good Cap Rate in Canada?

A “good” cap rate depends on property type, location, tenant strength, and investor goals.

Cap rate varies with property type, market, and other factors. This graphic illustrates a general range of low-risk to high-risk assets, but it's important to evaluate each deal against its individual metrics and your investment goals.

There is no universal “good” cap rate because every investment carries its own risk profile. Your “good” cap rate depends entirely on how much risk you're willing to take.

• Low-risk, core assets such as premium downtown offices or newer logistics facilities usually have lower cap rates because buyers value security and stable tenants.
• Secondary properties like neighborhood retail or older industrial buildings tend to sit in the mid-range.
• Value-add assets with short leases or repositioning potential typically offer higher cap rates to offset greater uncertainty.

These relative relationships have remained consistent over time, even as exact figures change. In many Canadian markets, stabilized multifamily and low-risk assets often trade in the 4% to 8% range, whereas higher-risk or repositioning opportunities may push yields upward. This logic applies to both land and built properties, as developers often compare yields on finished buildings with the underlying value of land ready for development.

How Do Cap Rates Reflect Market Conditions?

Cap rates move with shifts in interest rates, investor sentiment, and access to financing.

When interest rates drop, borrowing gets cheaper. Buyers can afford to borrow more to finance higher properties, pushing prices up and cap rates down.

When rates climb, it flips. Buyers want higher returns to offset their higher loan costs, so cap rates widen.

The same dynamic applies to investor confidence. When optimism is strong and competition intensifies, cap rates decrease. During periods of uncertainty, investors become more cautious and expect higher returns for taking on risk.

Investors also look at a property's “exit” or “terminal” cap rate when forecasting long-term returns. The exit cap rate represents the expected yield when the property is eventually sold and helps estimate future resale value. Comparing the entry and exit cap rates gives a clearer picture of how income growth, lease maturity, and market conditions could influence value over time.

What Are the Limitations of Using Cap Rates?

Cap rates are useful for quick comparisons but do not tell the full story.

Cap rates give you a quick snapshot, but they don't tell the whole story. They assume income and expenses remain steady, which rarely happens in real life. Vacancies pop up. Leases expire. Repairs cost more than you planned.

A low cap rate is not always “bad,” and a high cap rate is not automatically “good.” A property with a lower cap rate may offer stable, predictable income, while one with a higher cap rate might require more active management or involve greater risk.

That's why smart investors use cap rates as a starting point, not the finish line. You'll want to pair cap rates with other financial metrics, such as cash-on-cash return, debt service coverage ratio (DSCR), and internal rate of return (IRR) to make more confident, well-rounded investment decisions. Local market knowledge, tenant quality, and lease terms also play key roles in long-term performance.

A property that looks great on paper can drain cash fast if your cap rate assumptions miss real-world risk.

How Can You Use Cap Rates to Evaluate Property Deals?

Cap rates help investors test whether a property's income justifies its price.

The most effective approach is comparison. Look at recent transactions or commercial properties for sale in your market to see how yields align.

If a property's cap rate is well below comparable deals, it may be priced at a premium. If it's higher, there might be added risk or potential value. When you spot a property with a cap rate noticeably higher than comparable deals, you're likely looking at either hidden value or hidden problems. Dig deeper to understand why the cap rate is higher before you make an offer.

Cap rate movements also act as timing signals. When yields widen, prices may be softening, and entry points may appear. When they compress, competition is usually increasing.

Use cap rates as part of a broader framework that includes other measures of performance and financing.

Key Takeaways

Understanding cap rates gives you greater control and clarity when evaluating commercial properties. By combining this measure with local insight and long-term goals, you can identify the right balance between income stability and growth potential across Canada's commercial property market.

FAQs About Cap Rates in Canada

What is a good cap rate for commercial real estate in Canada?

It depends on the property type and location. Core assets in major cities often trade at lower cap rates because investors prioritise stability, while value-add or secondary assets offer higher yields to reflect additional risk.

How are cap rates different from ROI?

ROI measures total return, including financing and appreciation, while the cap rate focuses only on income relative to value. Cap rates isolate a property’s operating performance before debt and tax effects.

Do cap rates include mortgage payments?

No. Cap rates are calculated before financing costs. Mortgage terms affect ROI and cash flow, not the cap rate itself.

How often do cap rates change?

Cap rates move as markets shift. They tend to tighten when competition is strong or borrowing costs are low and expand when uncertainty rises or financing becomes more expensive.

Can I use cap rates for development land?

Cap rates are less useful for raw land because there is no income stream. Developers instead look at residual land value, project feasibility, and expected yield once the project is complete.