Why You Can't Just Look at a Cap Rate
I sat down for lunch a couple of days ago with an Ottawa realtor who specializes in income properties, to talk about rental properties in Ottawa and Toronto. He made some great points about what to look for when buying an income property, and debunked a few myths along the way. One in particular: that the only thing that matters when sizing up a property is the cap rate.
First off, what is a cap rate?
A cap rate compares the net income a property makes to its value: the income it generates after fixed and variable costs, divided by the value of the property. If you want to get technical, it's basically the discount rate of a perpetuity.
In plain terms, think of it as the return you'd get if you bought the property outright in cash: the net operating income that would go into your pocket with no loan to service. That's how you compare it with other places to put your money, like RRSPs or stocks. For most investors, it's also what you'd use to work out how much you have to service a mortgage with, and what's left over.
The cap rate is important, but it's not the only thing to look at. Different parts of a city have different cap rates, and they vary a lot. So also consider:
Tenant quality. This is a huge one. Buying a building with tenants means inheriting relationships. Reliable tenants who look after the place, are reasonable and pay a fair market rent should weigh heavily in a purchase. Chasing rent and ending tenancies cost money. A big cap rate doesn't protect you from a difficult tenancy. I have a friend who gets six angry voicemails a month from one tenant, who nonetheless pays on time and contributes to an 11% cap rate on a triplex. Yikes.
Property condition. Houses deteriorate; it's inevitable, and some cost more to fix than others. A fixer-upper means work ahead. A turnkey property means low maintenance costs for a while. A big cap rate is great, but not if you're facing a major renovation or a structural problem.
Appreciation potential. Another big one, especially in neighbourhoods that are improving or seeing new development nearby. Appreciation is equity, and equity lets you refinance, buy something else, or pay down your own home.
Income potential. If the rents could reasonably rise, that needs to be part of the picture too. In Ontario, rent increases are limited by the yearly rent increase guideline, so check what applies to each unit before counting on it.
Keep a balanced view. The cap rate matters, and any savvy buyer will scrutinize it if you sell, but it's one number among several.
What are your thoughts on cap rates?
Originally published September 15, 2013. Updated October 21, 2026: we added the note on Ontario's rent increase guideline, and removed links that no longer work, the realtor's name and photo, and links that had been added without our permission.