Cap rate — short for capitalization rate — is the single most cited metric in real estate investment analysis. You'll see it in listing brochures, investment memos, and broker presentations. You'll hear it in conversations between investors comparing deals across different cities. And you'll encounter it in your own underwriting every time you try to answer the basic question: is this property priced fairly for what it produces? This guide explains what cap rate actually measures, how to calculate it correctly, and — just as importantly — where it breaks down.
What Cap Rate Actually Measures
Cap rate answers one question: if you bought this property entirely with cash, what annual return would it generate? It strips out financing to measure the property's intrinsic income-generating ability. The formula is deceptively simple: divide the property's Net Operating Income (NOI) by its current market value or purchase price.
A property generating $18,000 in NOI that costs $300,000 to buy has a cap rate of 6%. This 6% is the property's unlevered yield — the return before any mortgage payment is factored in.
Why unlevered? Because cap rate is used to compare properties and markets, and different buyers will use different amounts of leverage. By stripping out the mortgage, you create an apples-to-apples metric that reflects the asset's income power regardless of how it's financed. When you see a cap rate of 4% in Vancouver versus 7% in Edmonton, that tells you Vancouver properties are priced for appreciation while Edmonton properties can generate more income relative to price. The cap rate difference doesn't mean Edmonton is a better investment — it means the two markets carry fundamentally different expectations about future growth.
Cap rate also moves inversely with price: when property prices rise faster than rents, cap rates compress. When prices fall or rents rise faster than prices, cap rates expand. Tracking cap rate trends in a market over time gives you a read on whether that market is becoming more or less expensive relative to the income it produces.
Calculating NOI: The Numerator That Matters
Cap rate is only as accurate as your NOI calculation. The formula: NOI = gross rental income minus vacancy minus operating expenses.
Gross rental income is the total rent if every unit is occupied 100% of the time — sometimes called "potential gross income."
Vacancy is typically modelled at 5% of gross rents as a minimum assumption (approximately one month empty per year), or higher in soft markets, during tenant transitions, or for properties with high turnover. In a market with 2% vacancy rates, you can tighten this assumption; in a market softening due to new supply, widen it.
Operating expenses include property taxes, insurance, property management fees (typically 8–12% of collected rents), maintenance and repairs (budget 1% of property value per year as a starting point), utilities paid by the landlord, and any condo or HOA fees.
What you do not include in NOI: mortgage payments (principal or interest), depreciation, or your own management time if you self-manage. Mortgage is excluded because cap rate is a pre-financing metric — including it would make the same property appear to have different cap rates depending on the buyer's leverage, defeating the purpose of the metric.
A common NOI mistake: accepting a seller's pro-forma NOI without scrutinizing every line item. Sellers routinely present best-case NOI figures — high rents, low vacancy, and thin expense assumptions. Always reconstruct NOI from actual revenue (rent rolls, bank statements) and verifiable expense receipts. The difference between a seller's pro-forma NOI and actual NOI often shifts the cap rate by a full percentage point or more, which on a $500,000 property represents a $50,000 to $100,000 valuation difference.
What Cap Rate Tells You — and What It Doesn't
Cap rate is excellent for several purposes:
- Comparing two properties in the same market: A higher cap rate means more income per dollar of price — all else equal, the higher-cap property is cheaper relative to what it produces.
- Tracking market trends over time: Cap rate compression (rates declining) means prices are rising faster than rents. Expansion means the reverse.
- Benchmarking a deal against market norms: If comparable buildings trade at 5.5% caps and your target is priced at a 4% cap, you're paying a premium — which is only justified if you have a compelling reason (value-add potential, below-market rents with near-term lease rollovers, or a specific strategic rationale).
Cap rate is a poor tool for:
- Comparing properties across very different markets: A 4% cap in Vancouver and a 4% cap in Saskatoon carry completely different growth assumptions, risk profiles, and liquidity characteristics. Treating them as equivalent because the cap rates match is a category error.
- Factoring in the impact of financing: A 7% cap rate property financed at 5% interest creates positive leverage — you're borrowing at 5% to invest at 7%, and the spread accrues to you. The same property financed at 8% interest would generate negative cash flow despite the attractive cap rate. Cap rate alone tells you nothing about what your actual cash returns will be.
- Evaluating properties with significant renovation potential: Cap rate is backward-looking — it measures current NOI, not what the property could generate after improvements. A deep value-add deal might have a terrible cap rate on current rents and an excellent one on stabilized rents after renovation.
Cap Rate vs Cash-on-Cash: Knowing Which Metric to Use
Cap rate and cash-on-cash return are complementary metrics that answer different questions. Use cap rate to evaluate the property itself — independent of how you finance it. Use cash-on-cash return to evaluate your actual investment — specifically, how much cash you put in versus how much cash you get back per year after paying the mortgage.
A property with a 6% cap rate financed at 4.5% interest (with 25% down) will generate a cash-on-cash return higher than 6%. You're borrowing money at 4.5% to invest at 6%, and the spread accrues to your equity. This is positive leverage — debt is working in your favour.
If your financing costs exceed the cap rate, you have negative leverage — every dollar of mortgage reduces your overall return below what you'd earn buying with cash. A 5% cap rate property financed at a 6% mortgage rate is a classic negative leverage scenario: the bank earns more on the property than you do.
The key insight for the current rate environment: in a rising interest rate environment, cap rates must rise (i.e., prices must fall relative to income) to maintain positive leverage. This is the mechanical reason why higher interest rates put downward pressure on property prices — when financing costs rise above prevailing cap rates, buyers can no longer make the numbers work, and prices must adjust until cap rates reflect the new cost of capital.
Cap Rate Benchmarks for Canadian and US Markets
Cap rate benchmarks vary significantly by property type and market. The figures below reflect multifamily residential market conditions as of 2024–2025 and should be treated as directional rather than definitive — market conditions shift, and local transaction data from a commercial broker will always be more current and accurate than any published guide.
Canadian multifamily residential:
- Vancouver: 3.5–4.5%
- Toronto: 3.5–4.5%
- Calgary: 4.5–5.5%
- Edmonton: 5.0–6.5%
- Halifax: 5.0–6.5%
US multifamily residential:
- Coastal gateway markets (NYC, LA, SF): 3.5–4.5%
- Sunbelt growth markets (Austin, Phoenix, Nashville): 4.5–5.5%
- Mid-size Midwest markets (Columbus, Indianapolis): 5.5–7.0%
- Rural and smaller markets: 7.0%+
Industrial and commercial cap rates differ from residential and are beyond the scope of this guide. As a general pattern, lower cap rates in major urban centres reflect investor expectations of stronger long-run rent growth and capital appreciation — not that these properties generate better current income. Higher cap rates in smaller markets reflect lower growth expectations and higher perceived risk, compensated by stronger current yields.
One final caution: published cap rate benchmarks are backward-looking. They reflect what properties have traded at, not what they should trade at given current conditions. A material shift in interest rates or local supply fundamentals can move cap rates by 50–100 basis points within a single cycle. Always verify current benchmark data with a local commercial broker or recent comparable sales before anchoring any underwriting to a figure from a guide that may be months out of date.