The capitalization rate — cap rate — is one of the most important numbers in commercial real estate. It is the primary metric used to value income-producing properties, and it directly affects how much a lender will lend against a commercial property. If you are working commercial mortgage files, understanding cap rates is not optional.
A cap rate is, at its core, a measure of investment yield. It tells you what percentage return a property generates on its value, before financing costs. Lower cap rates mean investors are paying more for a given level of income. Higher cap rates mean more income relative to price — typically because there is more risk involved.
The cap rate formula
Cap Rate = NOI ÷ Property Value
Or rearranged to solve for value:
Property Value = NOI ÷ Cap Rate
That second version is how appraisers and lenders use cap rates in practice. They determine the market cap rate for a given property type in a given location, then apply it to the NOI to arrive at a value estimate.
A practical example
Multi-unit residential property, 8 units in Hamilton, Ontario
Annual NOI: $92,000
Market cap rate for similar properties in this submarket: 5.5%
Implied value = $92,000 ÷ 0.055 = $1,672,727
The owner paid $1.85 million for the property. At the current NOI and a 5.5% market cap rate, the income approach value is approximately $1.67 million — below the purchase price. This affects how much the lender will lend.
This is why cap rate matters so directly for commercial mortgages: if the appraiser's income approach value (derived from market cap rate and NOI) is lower than the purchase price, the LTV calculation is based on the lower appraised value. The lender will lend a percentage of value — not of price.
What drives cap rates
Cap rates reflect the relationship between risk and return in a given market. The key factors:
- Property type — different asset classes carry different risk profiles
- Location — prime urban locations have lower cap rates than secondary markets or rural properties, because demand for the asset is higher and liquidity is greater
- Lease quality — a property with long-term leases to creditworthy tenants has lower risk than one with short-term month-to-month tenancies, and will trade at a lower (better) cap rate
- Interest rates — when interest rates rise, cap rates tend to follow, because investors require higher yields to compensate for higher financing costs; when rates fall, cap rates compress
- Market conditions — supply and demand for investment properties in a specific area affects cap rates the same way it affects any market
Market cap rates by property type in Canada (approximate, 2026)
These ranges reflect typical market conditions in major Canadian markets and vary significantly by city and submarket:
Multi-residential (urban, major cities): 4.0%–5.5%
Multi-residential (secondary cities / suburban): 5.0%–6.5%
Industrial (modern, leased): 5.0%–6.5%
Retail (necessity-based, strong tenants): 5.5%–7.0%
Retail (mixed or secondary): 6.5%–8.5%+
Office (urban, class A): 5.5%–7.0%
Office (suburban, class B/C): 7.0%–10%+
Rural or single-tenant commercial: 7.5%–12%+
These are market averages, not lender standards. Lenders typically use a stressed cap rate — slightly higher than market — to be conservative in their value assessment. A lender might apply a 6.5% cap rate to a property trading at 5.5% in the current market, which produces a lower value and therefore a smaller maximum loan. Always check what cap rate the lender's appraisal uses.
Cap rate, NOI and the relationship to DSCR
Cap rate and DSCR work together to determine how much a lender will advance on a commercial property. Here is how they interact:
The cap rate tells you what the market says the property is worth based on its NOI. The DSCR tells you whether the NOI is sufficient to service the proposed debt at a safe margin. Both metrics point to the same NOI number, and both constrain the maximum loan amount — from different directions.
When the cap rate is very close to or lower than the mortgage rate (which is common in low-cap-rate urban markets), the DSCR calculation is particularly tight. A property generating a 4.5% NOI yield against a 6.5% mortgage rate has almost no room in the DSCR — the property's income barely covers the debt service, which limits how much debt a prudent lender will put on it.
Property value: $2,000,000 | Cap rate: 4.5% → NOI = $90,000
Mortgage amount at 70% LTV: $1,400,000
Annual debt service at 6.5% over 25 years: approximately $119,000
DSCR = $90,000 ÷ $119,000 = 0.76x — well below the 1.20x minimum
The deal does not qualify at 70% LTV in this rate environment. The lender must reduce the loan amount until the DSCR reaches 1.20x — which may be well below 70% LTV.
This compression between cap rates and mortgage rates is a real issue in Canadian urban markets where property values have run ahead of income. Understanding it lets you assess commercial deals accurately before submission and set realistic expectations with borrowers about how much debt a given property can support.
Want to go deeper on this?
Our Commercial Mortgage course covers cap rates, NOI, DSCR, deal structuring and lender underwriting — with real income property files and small class sizes.
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