Cap rate (capitalization rate) is a property’s net operating income divided by its price: the yield it would earn if you bought it with cash. Because it leaves out financing, it lets you compare properties and markets on the same footing. This page covers the formula, a worked example, why cap rates differ between markets, how leverage turns a cap rate into your actual return, and what falling or rising cap rates signal. It is part of WealthNorth’s guide to real estate investing in Canada; to run the numbers for a specific property, use the rental property calculator.
The Cap Rate Formula
Cap Rate = (Net Operating Income (NOI) ÷ Purchase Price) × 100
| Component | Included in Cap Rate? | Notes |
|---|---|---|
| Gross rental income | ✅ Yes (starting point) | Market rents, fully occupied |
| Vacancy allowance | ✅ Yes (reduces income) | Typically 5% minimum |
| Property taxes | ✅ Yes (expense) | Actual or estimated |
| Insurance | ✅ Yes (expense) | Landlord policy |
| Property management | ✅ Yes (expense) | Even if self-managing |
| Maintenance / repairs | ✅ Yes (expense) | 1% of value/year typical |
| Mortgage payments | ❌ No | Cap rate is unlevered |
| Income taxes | ❌ No | Personal tax situation excluded |
Cap Rate Example Calculation
| Item | Monthly | Annual |
|---|---|---|
| Gross rent | $2,200 | $26,400 |
| Vacancy (5%) | ($110) | ($1,320) |
| Property tax | ($325) | ($3,900) |
| Insurance | ($100) | ($1,200) |
| Maintenance (1% of price) | ($267) | ($3,200) |
| Property management (10% of rent collected) | ($209) | ($2,508) |
| Net Operating Income (NOI) | $1,189 | $14,272 |
| Purchase price | n/a | $320,000 |
| Cap Rate | n/a | 4.46% |
Where to find cap rates for a market
Commercial real estate brokerages publish quarterly cap rate surveys for apartment buildings and commercial property in major Canadian cities; they are the usual reference for multi-family and commercial deals. There is no equivalent public series for individual condos and houses. The closest benchmark is gross yield (rent divided by price) from current price and rent data, which best cities for investment property ranks by city. A property’s cap rate will sit well below its gross yield once operating costs come off: in the example above, an 8.25% gross yield becomes a 4.46% cap rate.
Why Cap Rates Vary by Market
| Factor | Effect on Cap Rate | Example |
|---|---|---|
| Appreciation expectations | High expectations → lower cap rate | Toronto and Vancouver: buyers accept lower yields in exchange for expected price growth |
| Land scarcity | Scarce supply → lower cap rate | Vancouver: limited geography compresses yields |
| Rent control | Limits NOI growth → should raise cap rate | Ontario: the guideline limits increases for sitting tenants in units first occupied on or before November 15, 2018 |
| Population/migration growth | Higher growth → lower cap rate | Fast-growing cities attract buyers who expect rents and prices to rise |
| Interest rates | Higher rates → upward pressure on cap rates | Buyers need more income per dollar of price when borrowing costs more |
| Vacancy rates | Low vacancy → lower cap rate | A tight rental market makes income more reliable |
Cap Rate vs Cash-on-Cash vs Total Return
| Metric | What It Measures | Includes Mortgage? | Includes Appreciation? |
|---|---|---|---|
| Cap Rate | Unlevered income yield | ❌ No | ❌ No |
| Cash-on-cash | Return on actual cash invested | ✅ Yes | ❌ No |
| Total Return | Full investment return | ✅ Yes | ✅ Yes |
In high-appreciation markets, total return (cap rate + appreciation) may be 8–10% even with a 3% cap rate, if the property appreciates 5–7% annually. The danger is underwriting a low-cap-rate purchase that depends on appreciation that may not materialize.
Positive vs Negative Leverage
| Scenario | Cap Rate | Mortgage Rate | Leverage Effect | Cash-on-Cash vs Cap Rate |
|---|---|---|---|---|
| Positive leverage | 6% | 4.5% | Amplifies returns | Cash-on-cash > cap rate |
| Neutral leverage | 5% | 5% | No amplification | Cash-on-cash ≈ cap rate |
| Negative leverage | 3.5% | 5.5% | Reduces returns | Cash-on-cash < cap rate |
When your mortgage rate exceeds your cap rate, every dollar of borrowed money reduces your return on equity. Buying at a low cap rate with a higher mortgage rate and a minimum down payment builds negative cash flow into the deal; how to find or create properties where rent covers costs is covered in positive cash flow rental property.
Cap Rate Compression: What It Signals
| Cap Rate Signal | Implication |
|---|---|
| Compressing (falling) | Properties getting more expensive; market may be overheated; income yield thinning |
| Expanding (rising) | Properties getting cheaper relative to income; better entry point for income investors |
| Stable | Balanced market; price and income growing roughly together |
| Extremely low (< 3%) | Market driven almost entirely by appreciation thesis; income investors crowded out |
Bottom Line
Cap rate is the cleanest single metric for comparing rental properties across markets: it removes the noise of your specific financing and focuses on whether the property generates adequate income for its price. A 3% cap rate in Toronto is not inherently bad if you are buying for long-term appreciation in a constrained supply market. A 7% cap rate in a smaller market is not automatically superior if the city has weak demographics and limited appreciation potential. Use cap rate to compare within and across markets, and pair it with cash-on-cash return to understand the actual return on your invested capital given current financing costs.
Related reading
- Rental property calculator: cash flow, cap rate and cash-on-cash return
- Is buying a rental property worth it?
- REITs in Canada, where the same income-yield logic applies to listed property