A calculator can give you the answer, but it can’t teach you the math.

A few years ago, a broker closed the sale of a shopping centre at a six per cent cap rate. To the buyer, it looked like a steal, especially in a market where prime retail properties were trading in the mid-fours. So, how did this happen?

The answer lay in a leaking roof. A pre-closing inspection revealed millions of dollars in needed repairs. The buyer negotiated a lower purchase price, and the deal went through.

But here’s where the story gets tricky. That sale later became a “comp” (short for comparable) for another listing. The new broker touted the six per cent cap rate without mentioning the roof issues, the vacancies, or the short-term leases.

And that’s the danger of relying on a single number. It won’t teach you the whole story behind the math. 

Rule No. 1: Never Rely on a Single Number

A capitalization rate (cap rate) is deceptively simple: Cap Rate = Net Operating Income (NOI) ÷ Purchase Price.

It represents the annual return an investor would earn on an all-cash (unlevered) purchase, excluding financing costs. NOI is the property’s revenue after operating expenses but before debt service, depreciation or taxes. In short, cap rates measure operational performance - nothing more.

If I told you I bought a retail plaza at a six per cent cap, what would that actually tell you?

• It’s a data point for similar assets.
• It’s meaningless without context: location, tenant credit, lease terms, building condition, or whether the NOI is stabilized or in-place.
• Too often, investors and brokers treat cap rates like stock tickers. In reality, they reflect risk, market sentiment, asset quality, ease of management and income duration. 

Rule No. 2: Use cap rates only on stabilized income

Stabilized NOI reflects long-term, sustainable performance based on market rents, typical expenses and normalized vacancy. In-place NOI is today’s snapshot, useful for cash flow but risky for valuation.

Consider a retail centre anchored by a national tenant like Target. The tenant’s lease expires in eight months, and renewal talks are stalled. Valuing the property on current (in-place) rent assumes the tenant will stay at the same rate. But if the replacement rent drops by 20 per cent, that six per cent cap rate becomes a 7.5 per cent reality overnight.

Conversely, a strip mall with 25 per cent vacancy, but signed LOIs from credit tenants can justify a stabilized valuation. The goal is simple: compare apples to apples.

Caution: Listing brokers work for sellers. Their “pro forma stabilized NOI” often assumes optimistic scenarios. It’s only natural: if you want to sell the positive side, you have to sell the dream. Always rebuild the numbers yourself.

A related trap is the covered land play. A site with a single-tenant net lease might generate enough income to cover holding costs during rezoning. Its 2.68 per cent cap rate shouldn’t be compared to that of a fully leased, well-anchored centre. 

Rule No. 3: Cap rates are risk-adjusted returns

Think of a cap rate as the premium investors demand above the risk-free rate, currently the Government of Canada 10-year bond yield at ~three per cent (as of Q3 2025).

Real estate typically trades at a spread of one per cent to 10 per cent above bonds, depending on risk:

You’ll rarely see cap rates below bond yields unless there’s embedded upside, such as a site with density bonuses trading at 2.75 per cent because the buyer plans a much larger multifamily development. Cap rates in this covered play are irrelevant.

Rule No. 4: Don’t trust. Verify

No two assets are identical. A standalone Tim Hortons with a 15-year NNN lease and rezoning potential may trade at 4.35 per cent. The buyer? A family seeking inflation-protected yield. No effort required to generate yield for the next decade.

Compare that to a 1980s office tower in downtown Regina with 40 per cent vacancy and exposure to broader economic volatility. What repairs, upgrades and effort would be required to create a steady stream of income over the next decade?

Be honest about the work ahead. If you’re willing to lease vacant space, fund capex, or reposition the asset, a higher cap rate (lower price) is justified. If you want passive income with minimal headaches, expect to pay for it with a lower cap.

Rule No. 5: People buy narrative, resist facts

When bond yields rise, cap rates should follow. Capital chases the best risk-adjusted return - whether in bonds, equities or real estate.

But CRE pricing can be very “sticky.” Long-term holders often resist selling at higher caps (lower prices).

Don’t be fooled: if bond rates are substantially higher than the year before, cap rates should be higher too. And vice versa.

Markets are markets, they tend to be quite efficient in adjusting pricing, even if there is a delay.

Rule No. 6: Information without understanding is noise

Why choose CRE when bonds pay three per cent-plus with zero management?

First, it’s not for everyone. Many investors should buy bonds!

But for those who look for advantages bonds don’t offer, CRE can provide:

• Inflation hedge: Most retail leases include rent (NOI) escalations and on renewal, reset to market.
• Tax efficiency: CCA, cost segregation and refinancing.
• Value creation: Repositioning, mortgage burn-down, or future development. A paid-off property with redevelopment upside is a perfect asset for the right investor.
• The trade-off? Illiquidity and active management. As I heard one investor put it: “I’ll take a five per cent cap on a grocery centre over a 3.5 per cent bond any day - if I can sleep at night.”

The question is: Can you sleep at night?

The bottom line

Cap rates are snapshots. The best investors blend numbers with narrative. They ask:

• What’s the story behind the NOI?
• Who’s the tenant, and how long will they pay?
• What does the roof (or the HVAC, or the parking lot) really need?
• What’s my exit plan?
• Can I sleep at night?

In short, mastering cap rates means looking beyond the calculator to understand both the math and the story behind them.