Understanding Cap Rates: A Complete Guide for Commercial Property Investors

What Is a Capitalization Rate?

The capitalization rate—or cap rate—is the most important metric in commercial real estate investing. It represents the expected rate of return on a property based on its income, expressed as a percentage.

The Formula:

Cap Rate = Net Operating Income (NOI) ÷ Property Value × 100

Or, rearranged:

Property Value = NOI ÷ Cap Rate

Example:

A property generates $100,000 NOI and sells for $1,666,667.

Cap Rate = $100,000 ÷ $1,666,667 = 6%

Why Cap Rates Matter

Cap rates serve several critical functions for commercial property investors:

1. Property Valuation Cap rates allow you to estimate property value based on income. If you know the NOI and the typical cap rate for that property type, you can estimate value.

2. Investment Comparison Cap rates let you compare properties with different prices, sizes, and income levels on an apples-to-apples basis.

3. Market Analysis Tracking cap rate trends tells you whether the market is heating up (falling cap rates) or cooling down (rising cap rates).

4. Return Expectations The cap rate represents your unlevered return—what you'd earn if you paid all cash for the property.

Cap Rate vs. Other Return Metrics

Cap rate is just one way to measure returns. Understanding how it relates to other metrics helps you see the full picture.

Cap Rate vs. Cash-on-Cash Return

Cap rate is unlevered; cash-on-cash is levered.

• - **Cap Rate**: Return on total property value (as if you paid cash)
• Cash-on-Cash: Return on your actual cash invested (after financing)

• Example:
• Property value: $2,000,000
• Down payment: $600,000 (30%)
• NOI: $120,000
• Annual debt service: $72,000

Cap Rate = $120,000 ÷ $2,000,000 = 6% Cash-on-Cash = ($120,000 - $72,000) ÷ $600,000 = 8%

Leverage increases your cash-on-cash return above the cap rate (when done properly).

Cap Rate vs. IRR

• Internal Rate of Return (IRR) considers the full investment lifecycle including:
• Initial purchase
• Annual cash flows
• Appreciation
• Final sale

Cap rate is a snapshot; IRR is a movie.

What Affects Cap Rates?

Cap rates aren't random—they're driven by fundamental factors that affect perceived risk and return expectations.

Property-Specific Factors

• **Tenant Quality**
• National credit tenants = lower cap rates
• Local tenants with thin financials = higher cap rates
• The difference can be 100-200 basis points

• **Lease Terms**
• Long-term leases (10+ years) = lower cap rates
• Short-term or month-to-month = higher cap rates
• Triple net leases = lower cap rates than gross leases

• **Building Quality**
• Newer, well-maintained buildings = lower cap rates
• Older buildings needing capital = higher cap rates
• Functional obsolescence increases cap rates

• **Location**
• Prime locations = lower cap rates
• Secondary locations = higher cap rates
• Growing areas vs. declining areas

Market Factors

• **Interest Rates**
• Rising interest rates → rising cap rates
• Falling interest rates → falling cap rates
• This relationship isn't perfect but is directionally consistent

• **Capital Availability**
• More capital chasing deals → lower cap rates
• Tight capital markets → higher cap rates

• **Economic Conditions**
• Strong economy → lower cap rates
• Recession concerns → higher cap rates

• **Supply and Demand**
• More buyers than sellers → lower cap rates
• More sellers than buyers → higher cap rates

GTA Cap Rate Ranges by Property Type

Cap rates vary significantly by property type. Here's what you'll typically see in the Greater Toronto Area:

• **Industrial Properties: 4.5% - 6.5%**
• Highest demand, lowest vacancy
• Strong tenant covenants
• Limited new supply
• Prime locations approaching 4%

• **Multi-Family Residential: 3.5% - 5%**
• Strong rental demand
• Predictable income
• Favorable financing
• Purpose-built rentals at premium

• **Retail - Grocery Anchored: 5% - 6.5%**
• Essential retail proving resilient
• Strong anchor tenants
• Good foot traffic
• Location dependent

• **Retail - Unanchored Plazas: 6% - 8%**
• Higher risk without anchor
• Tenant mix critical
• More location sensitive
• Wider range of outcomes

• **Office - Downtown: 5.5% - 7%**
• Post-pandemic uncertainty
• Flight to quality
• Tenant preference for Class A
• Secondary office struggling

• **Office - Suburban: 6.5% - 9%**
• Remote work impact
• Conversion potential matters
• Parking advantages
• Highly variable by location

How to Use Cap Rates in Practice

Buying a Property

When evaluating a purchase:

1. 1. **Verify the NOI.** Don't trust the seller's pro forma. Request actual income and expenses. Adjust for market rents if below or above.

1. 2. **Research comparable cap rates.** What have similar properties traded for recently? Use multiple data points.

1. 3. **Consider your target return.** Does this cap rate meet your investment criteria after considering your financing?

1. 4. **Think about the future.** Is this cap rate sustainable? Will NOI grow or decline?

Selling a Property

When preparing to sell:

1. 1. **Maximize NOI.** Higher NOI = higher value. Review all income and expenses for opportunities.

1. 2. **Understand buyer expectations.** What cap rate will buyers expect for your property type and location?

1. 3. **Position appropriately.** Highlight factors that justify a lower cap rate (tenant quality, lease terms, location).

Holding a Property

For ongoing management:

1. 1. **Track your cap rate.** As NOI and values change, so does your effective cap rate.

1. 2. **Benchmark against the market.** Are you underperforming or outperforming similar properties?

1. 3. **Consider alternatives.** If you could sell at a 5% cap rate and buy at 7%, does repositioning make sense?

Common Cap Rate Mistakes

1. Comparing Different Property Types A 7% cap rate on a strip mall isn't comparable to a 7% cap rate on an industrial building. Risk profiles differ.

2. Using Pro Forma NOI Pro forma assumes perfect occupancy and optimistic rents. Real value is based on actual—or realistically achievable—NOI.

3. Ignoring Capital Expenditures A 6% cap rate with a $500,000 roof replacement coming isn't really 6%.

4. Confusing Cap Rate with Return Cap rate is unlevered return. Your actual return depends on financing, appreciation, and capital events.

5. Expecting National Data to Apply Locally Cap rates are local. National averages don't reflect your specific market.

The Current Cap Rate Environment

As of early 2025, the GTA cap rate environment reflects:

• - **Interest rate stabilization** after significant increases
• **Strong fundamentals** in industrial and multi-family
• **Uncertainty** in office sector
• **Selective retail** performing well in the right locations
• **Active investor interest** but disciplined underwriting

Cap rates expanded in 2023-2024 as interest rates rose. Whether they compress again depends on rate movements and economic conditions.

Making Cap Rates Work for You

Understanding cap rates helps you:

• - Value properties accurately
• Identify opportunities
• Negotiate effectively
• Make informed hold/sell decisions
• Communicate with lenders and investors

The cap rate is a tool—powerful when used correctly, misleading when misunderstood.

Get Expert Investment Analysis

Whether you're buying, selling, or evaluating your current portfolio, accurate cap rate analysis is essential. Our team provides detailed property valuations based on current market conditions.

Request a property valuation with cap rate analysis