Cap rate is a term that you will often hear investors use when evaluating their expected return on an investment, in this case, a real estate investment.
Cap rate stands for “capitalization rate” and it’s calculated by dividing an investment property’s net operating income by its present value.
The net operating income generally refers to the rent that is generated by the property minus any expenses needed to run the property. These expenses include maintenance, taxes, and utilities, but do not include any financing or purchasing costs.
This represents the challenge when strictly using cap rates to evaluate a real estate investment. The formula doesn’t incorporate either leverage or property appreciation into the equation, which are two of the biggest advantages to investing in real estate.
Having said that, understanding and utilizing cap rates as a tool when looking at real estate investments is important, especially for value-based investors as opposed to growth-focused investors. It’s also useful when comparing different investment options to each other.
So what is a good cap rate?
Simply put, a low cap rate means less risk, a higher cap rate means more risk.
Having said that, a lower cap rate also means a lower return on your capital.
Typically, residential real estate will have a lower cap rate than commercial real estate. Residential tends to be less risky because people need a place to live, but in turn, the rental rates are typically much lower than commercial.
Likewise, large cities like Toronto tend to have lower cap rates than smaller areas like Waterloo. The reason for this is that large cities tend to offer less price fluctuations making them less risky. On the flip side, the lower purchase prices in smaller areas tend to give them higher return on capital.
Toronto is one of the most stable real estate markets in the world, and as such our cap rates are relatively low – meaning the risk is low, but the return based strictly on rental income is also quite low.
For reference, our cap rates in Toronto come in at around: 2 – 2.5% for condos, 3.5% for houses, and 4 – 6% for commercial properties.
Keep in mind, that while cap rates in a place like Calgary for instance may be 1 or 2% higher than in Toronto, the overall market in Calgary has shown much lower price appreciation. This means that while the return based on rental income may be stronger in Calgary, the overall investment return has been much stronger in Toronto over the past several years.
In summary, the cap rate is an important tool that you can use to evaluate a property strictly based on its risk and its income potential. It doesn’t take into account leverage, property appreciation, or even any potential value that can be added to a property.