Cap Rates In Real Estate Explained | Elevate Realty (2024)

To find the cap rate, you divide the yearly money you make from renting (called annual net operating income) by the property’s value.

The net operating income is the rent you get minus costs like utilities, insurance, property tax, condo fees, maintenance, and accounting for vacancies.

No Appreciation Included: Cap rate doesn’t consider the property’s appreciation. Even if a property has a high cap rate, it might not be the best investment. To know that, also check the total returns, including appreciation.

No Mortgage in the Mix: Cap rate compares returns without including mortgage costs. Some people miss this, but it’s crucial. Remember, higher leverage usually means better expected return on investment, but it increases risk.

Use Current Market Value: When calculating cap rates, use the property’s current market value. Don’t base it on the purchase price from years ago. Houses vary a lot, considering size, features, condition, and parking, so it’simportant to get an accurate market value if you bought it a while ago.

Renovations Matter: If you renovated before renting, your renovation cost might be less than teh actual market value after you complete renovations so always use market value. Using your cost can inflate cap rates and not show the real picture.

In a nutshell, cap rates help us understand how good an investment is for making money through rent. Just be careful not to rely on it alone. Look at the bigger picture, including property appreciation and the real market value. That way, you’ll make smarter investment decisions.

Cap rates depend on interest rates.

If it’s more expensive to borrow money, investors want higher cap rates to make their investments worthwhile.This adjustment in the market can happen by lowering property values, raising rents, or both.

Typical Toronto Cap Rates (as of November 2023):

• Toronto condo cap rate is at 3-3.5%
• Toronto single family home cap rate is at 3.5-4%
• Toronto multi-familyhome cap rateis at4.5%+
• Toronto accessory dwelling unit cap rate is at 8%+

We prefer low-risk real estate investments and aim for at least break-even cash flows.

Ideally, we want a bit of positive cash flow after covering the monthly mortgage, allowing us to add to our emergency fund or handle unexpected expenses. We’ve seen how crucial this is as interest rates rise.

It’s not straightforward because when interest rates are lower, the percentage of the mortgage payment that goes toward the principal is higher. So, to break even, you need a bigger buffer on the cap rate above the interest rate.

When rates are higher, the principal paydown percentage is lower, requiring less of a gap between the cap rate and interest rate.

As of November 2023, we are aiming for a 5.5% cap rate to break even.

You can make your investment returns better by getting more rent on the property, such as:

• upgrading a unit
• adding more bedrooms to a unit
• increasing the number of units in a house
• adding a backyard house

1. Variations By City And Type

Cap rates vary for different types of properties and different cities. So instead of just cap rates, a total return analysis should include appreciation and value-add gains too (see point 4).

Typically, single family homes have lower cap rates compared to multi-family homes, which are both better than condos.

Cities with great cap rates might also compensate for lower appreciation potential. Take Calgary, for instance, where cap rates are higher than Toronto, but with minimal appreciation.

This is why we prefer Toronto freeholds, since they offer a good balance of good cap rates, strong appreciation prospects, and various options for value-add gain.

2. Learning From Toronto Condos

In Toronto’s condo market, some investors took on low cap rates and negative cash flows for potential higher appreciation. Now, with slowing appreciation, this strategy is riskier. Balanced investments, factoring in cap rates and appreciation, tend to be more reliable.

3. Neighbourhood Matters

4. Don’t Forget About Value-Add Gains

When you do renovations yourself, how much you put in might be lower than how much it’s worth afterwards, and that difference is your value-add gain.

In addition to boosting your returns, engaging in value-add projects also lessens investment risk. This is because your returns are spread across more categories, adding to market appreciation and rental income.

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• Real Estate Investing Basics
• How Much Capital You Need
• Cash Flow & Investment Return Projections
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