Cap rate is the most quoted number in investment real estate and the one most often used to mean something it does not mean. It is worth being precise about it, because a small error in how it is calculated moves a purchase price by six figures.
The definition
Capitalisation rate is net operating income divided by price. That is the whole formula. A building producing $120,000 of NOI, bought for $2,400,000, was bought at a 5.0 per cent cap rate.
Two things follow immediately. First, cap rate is an output of a transaction, not an input — it describes what a buyer paid relative to income. Second, it is only as reliable as the NOI it is built on, and NOI is where the arguments happen.
What it does not include
Cap rate ignores financing entirely. Two buyers paying the same price for the same building buy at the same cap rate, even if one is paying cash and the other is leveraged to seventy-five per cent. Their returns will be completely different. Cap rate measures the asset; it says nothing about the investor.
It also ignores time. It is a snapshot of one year’s income against price. It does not account for rents that are below market and will rise, a lease that expires in fourteen months, a roof with two years left, or a neighbourhood that is changing. Everything that makes one building a better buy than another at the same cap rate lives outside the formula.
Where the NOI goes wrong
Most disputed cap rates are really disputed NOIs. The recurring problems:
- Management left out. If the seller manages the building themselves, a market management fee still has to be deducted. Otherwise the cap rate is quietly assuming the buyer works for free.
- No capital reserve. Roofs, boilers, windows, parking. These do not appear on a tax return but they are real annual costs. Underwriting without a reserve overstates NOI every time.
- Actual vacancy instead of market vacancy. A building that happened to be full last year is not a building with zero vacancy risk.
- Pro forma rents. A seller showing what rents “could be” after renovation is showing you their business plan, not the building’s income. Underwrite what is in the leases.
Correct all four on a typical small multifamily building and the cap rate the seller quoted often falls by fifty to a hundred basis points. That is the gap between a good buy and an expensive one.
How to use it well
Cap rate is a comparison tool, and it works when both sides of the comparison are calculated the same way. Use it to rank similar buildings in the same market, not to decide whether a deal is good in absolute terms. For that you need the debt service coverage, the cash-on-cash return after financing, and a view on where rents and the capital plan are going.
And treat a quoted market cap rate as a rough bracket rather than a fact. The range for a Class B walk-up in Edmonton is not the range for a stabilised Class A building in Calgary, and neither is published in a way you can rely on without checking the actual comparable sales.
Talk it through with Rimrock
Rimrock Sales & Leasing works with owners, investors and tenants across Calgary, Edmonton and Lethbridge. Get in touch or call 403-910-4611.