Cap Rate: The First Yardstick in Commercial Property Valuation
A seller says the building is worth $5M. How do you know if that’s fair? Commercial real estate isn’t priced per square foot — it’s priced on what the building earns. Cap rate is the tool that converts "earns" into "worth."
What is a cap rate and how do you calculate it?
Cap rate = NOI (Net Operating Income) ÷ purchase price × 100%. It measures the unleveraged annual return if you bought the building all-cash. A building with $400K NOI selling for $8M has a 5% cap rate. Counterintuitively, a lower cap rate means a more expensive building — you’re paying more principal for the same income. In GTA practice, cap rate is the first screen for any income property, ahead of price-per-square-foot.
Source: GTA commercial valuation practice / CBRE market data (2026)
I’m Arthur Zhao. The most common mistake I see from buyers crossing over from residential is comparing commercial buildings on a price-per-square-foot basis. But a commercial building isn’t something you live in — it’s an income machine. Its value comes from the net income it produces, not its size. The ratio that ties income to price is the cap rate. Understand it, and you’ll see why two similarly-priced buildings can be a great deal and a trap.
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NOI comes first
Two uses: checking price and setting price
Why a lower cap rate is more expensive
Directional 2026 GTA ranges by type
• Industrial: ~5-6%, prime core industrial compressing to 4-4.5%
• Multi-family / apartment: ~4-5%
• Retail: ~5-6%, higher for community strip
• Office: the widest spread — prime Class A can reach 5-6%, suburban / B-C meaningfully higher
Use these to judge whether an asking price sits inside a reasonable band or is clearly off.
⚠️Don’t apply a city-wide average cap rate to a specific building. On the same street, a unit leased to a national chain with 10 years remaining and one leased to a local shop expiring next year can justify cap rates 1.5%+ apart — a 20-30% swing in value.
💡 Cap rate is a static snapshot — it assumes NOI stays flat and you hold forever. It ignores future rent growth, the cash-return boost from leverage, and appreciation. Never treat a pretty cap rate as the sole reason to buy. It’s a screening and comparison tool, not the whole thesis.
The real battle is inside the NOI
ℹ️When a seller prices off a “market cap rate,” ask whose comps set that rate and whether they match this building’s lease quality. Have your broker pull actual sold cap rates from the same submarket instead of trusting one isolated figure.
Frequently Asked Questions
What’s a "good" cap rate?
There’s no absolute good or bad — only relatively reasonable. Compare cap rates against same-area, same-type, same-lease-quality assets. A low cap rate means expensive but usually more stable with growth upside; a high cap rate means cheaper but riskier. Whether you want stable cash flow or appreciation upside decides which end suits you.
Is cap rate the same as my actual cash return?
No. Cap rate assumes an all-cash purchase with no financing. Your actual cash-on-cash return depends on how much you borrowed and at what rate. With leverage, as long as your loan rate is below the cap rate, your cash return is amplified above the cap rate; if it’s higher, your return is compressed.
Do I subtract the mortgage from NOI?
No. NOI is an operating-level figure and deliberately excludes mortgage interest, principal, depreciation, and capital expenditures, so buyers using different financing can compare the same building on one yardstick. Your mortgage payment enters only when you calculate cash-on-cash return.
Why is the seller’s cap rate higher than the one I calculate?
Because sellers usually quote an optimistic pro forma NOI — understated vacancy, omitted expenses, market rents rather than actual in-place rents. A higher numerator makes the cap rate look better. Always rebuild the NOI from actual leases and statements, then compute your own cap rate.
Arthur Zhao
Real Estate Broker · FRI · ABR · SRS · PSA · MCNE · E-PRO · CLHMS & GUILD Elite · REAIS
VP & Branch Manager, Bay Street Group Inc.
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