If you were a commercial real estate investor, a “cap rate” would be a guiding principle that shapes nearly every decision you make. People buying or selling residential homes use the term less often, but the concept still applies. 

Even if you never plan to rent out a unit or flip a property for a profit, you will still benefit from paying attention to cap rates. Understanding the percentage can be instrumental in finding hidden gems while avoiding houses that only look good on the surface. 

Your home, no matter what you do with it, is an investment. Even if you just “live there,” thinking like an investor will help you acquire a financially valuable asset and a place you love that will soon be full of memories. 

Buying a home rather than an income property is more of an emotional experience. However, any real estate acquisition is all about the numbers when looking at it from a business perspective. In this post, we’ll talk about what cap rate means, and how to decipher it so you buy or sell with confidence. 

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What Does Cap Rate Mean in Real Estate?

What is a cap rate and how does it help you choose what property to focus on and what to avoid? (Officially, the correct term is “capitalization rate,” but that is a bit of a tongue twister during casual conversation, hence the short form.) 

The simple definition is a cap rate is the rate of return from an investment property based on how much income you expect the property to generate. (Or, in residential, how much it could generate if you were to find a tenant rather than live there yourself.) There are a few variables to factor in. 

You may not know with certainty how much income a unit will provide. However, you can get an estimate based on how much a tenant is currently paying, if there is one. If the unit is vacant, you can investigate and find out how much similar properties are earning. 

Next, you’ll estimate all of your expenses to maintain the property, such as property taxes, repairs, and insurance. (Oddly enough, your monthly mortgage doesn’t factor in with this equation. That’s because we’re calculating cap rate, not cash flow, which is a completely separate topic altogether.)

Optimism may be a feature of real estate investing, but you don’t want to be too generous with these estimates. Even if you can’t get exact figures, it’s still critical to be realistic. A local real estate team that understands the finer details of investing can help you with this background research. 

Are you on the hunt for your next investment or residential property? The posts below can help you zero in on the perfect fit:

How to Calculate Cap Rate

Once you have accurate information, the actual formula for calculating the cap rate is fairly simple. Simply subtract your estimated expenses from the expected revenue to come up with your net operating income (NOI). You now have all of the necessary data for the cap rate formula. 

All that’s left, at least in terms of the math, is to divide your NOI by the purchase price (or market value). To keep the numbers simple, let’s look at a property that costs $5 million with an annual income of $300,000. 

$300,000 ÷ $5,000,000 = 0.06 or 6%

Is this a good number for a cap rate? It depends, and this is where the concept can be confusing, especially to a new buyer or investor. 

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Is a Higher Cap Rate Better?

A higher number can look more impressive on paper. However, a low number can also be preferable depending on your goals as an investor. Generally speaking, a high cap rate represents greater profit potential, but also more risk. 

A commercial plaza in a smaller town valued at $2 million and earning $200,000 per year has a 10% cap rate. It might look like the opportunity of a lifetime.

If all goes right, this is the type of investment that grows substantial wealth over time. 

However, there is so much that could go wrong.

A long-time tenant could leave. In a less populated town or city, the unit could sit empty for months. In the meantime, you still have all of the carrying costs. 

Do you plan to invest in Toronto real estate? The posts below can help you make the right decisions:

Low Cap Rates Can Offer Some Advantages

A lower cap rate comes with less risk, but also less potential, which isn’t always a bad thing. Let’s look at an example you might find in Toronto real estate. 

Imagine that you’re looking at a Toronto tri-plex for $2 million. (Again, we’ll keep the numbers simple for illustrative purposes, but they could be different depending on the market.)

Your expenses, not including your mortgage, work out to $3,500 per month or $42,000 annually. 

By using data from the Toronto Regional Real Estate Board, or better yet, working with a real estate team to determine the potential before you place an offer, you estimate you can rent out each unit for approximately $2,800. 

  • Your expected net income is $8,400 per month ($2,800 x 3) for a gross of $100,800 per year. That is a net of $58,800 after subtracting your $42,000 expenses. 
  • Divide $58,800 by the $2 million purchase price, and you have a cap rate of .0294 (approximately 3%.)

It’s nowhere near as exciting as a 10% cap rate opportunity, but it’s also not as risky, especially with so many tenants in Toronto in search of housing. For a conservative, detail-oriented investor, this triplex could represent an outstanding opportunity. 

When buying real estate, the importance of the right location cannot be overstated. The posts below will give you a starting point: 

Cap Rates and Your Primary Residence

You will almost never hear someone bring up cap rates when they’re searching for a house to call their own. However, buying a house with income potential is actually one way for first-time buyers to get into the market. 

Lenders will often authorize a higher mortgage based on the income potential. Plus, you’ll have extra funds to help with your carrying costs every month. Imagine going from being a tenant to becoming a full-fledged real estate investor in such a short time. It can and does happen when you realize the possibilities. 

Knowing the potential cap rate can help you identify a fantastic home and fully understand its value. For example, think back to that triplex we discussed. 

You could live in one unit and rent out the other two to help cover your expenses, and maybe even generate a little extra income. The official cap rate doesn’t change. (Even though you’re not getting paid for your share, your unit is still technically worth $2,800 each month.) 

Any way you look at it, buying a house is an investment. Knowing all of your numbers and stats will allow you to make your purchase as safe and financially rewarding as possible!

Our Midtown Toronto real estate agents are here for you. Reach out to us at david@batorigroup.com, bobby@batorigroup.com or call (416) 485-7575 with any questions.