What a Cap Rate Is and How to Calculate a Rental Return

A cap rate is net operating income divided by purchase price, expressed as a percentage, and it’s the single number you’ll hear quoted most often when someone talks about a rental property’s return. If you’re comparing a Toronto condo against a house as a rental, sizing up whether to sell an existing investment, or just tired of nodding along when an agent mentions a cap rate without explaining it, this guide works through the formula with a full example, what counts as income and expense in that calculation, and why a healthy cap rate in the GTA tends to look smaller than one in a lot of other markets. It also covers the 1% rule and the gross rent multiplier, the two faster, rougher shortcuts you’ll run into alongside it. For everything else that comes with buying an investment property in the city, see our complete Toronto real estate guide, and browse the rest of our guides for the related owner and investor topics below.

What a cap rate measures

The formula is short: cap rate equals net operating income divided by purchase price, then multiplied by 100 to get a percentage, the same definition CMHC uses in its own Rental Development Survey glossary. Net operating income, usually shortened to NOI, is what a property earns in a year after operating costs but before anything related to financing. That last part is the detail most people searching for this term haven’t connected yet: a cap rate deliberately ignores your mortgage. It answers one specific question, what does this property earn relative to what it costs, independent of how any particular buyer chooses to pay for it.

Because the mortgage is excluded, a cap rate isn’t the same thing as your cash flow once you own the place. Two buyers can look at the identical property, land on the identical cap rate, and still walk away with completely different monthly numbers once one of them pays cash and the other borrows 80% of the purchase price at a given interest rate. The cap rate tells you about the property. Your financing tells you about your own return on it, and those are two separate calculations that this guide deliberately keeps apart.

What counts as net operating income, and what doesn’t

Net operating income is gross rental income minus operating expenses, and the list of what belongs in “operating expenses” is narrower than a lot of first-time landlords expect. It includes property tax, insurance, a realistic allowance for maintenance and repairs, condo fees where the property is a condo, and a vacancy allowance that accounts for the property sitting empty between tenants or during a turnover. What it specifically excludes is your mortgage payment, both the interest and the principal portion. This is the single most common point of confusion on this topic: a cap rate is calculated before financing, full stop, so a property’s cap rate doesn’t change depending on whether you put down 20% or 80%, and it doesn’t change based on the interest rate you personally qualify for.

It also excludes capital expenditures in the sense of a major one-time replacement, a new roof or a furnace, as distinct from the ongoing maintenance reserve that anticipates smaller, regular repairs. Some investors build a capital reserve into their own underwriting anyway, and that’s a reasonable thing to do for your own planning, but it isn’t part of the standard NOI calculation that produces a comparable cap rate across properties.

A worked example on a GTA rental property

Here’s a full calculation using illustrative numbers, not a claimed market average for any specific neighbourhood or building type. Say you’re looking at a property priced at $650,000, with a realistic achievable rent of $2,500 a month, or $30,000 a year in gross rent.

Subtract the operating expenses from that gross figure. Property tax runs $2,800 a year. Condo fees, if it’s a condo, run $550 a month, or $6,600 a year. Insurance costs $300 a year. A maintenance and repair allowance of $500 a year covers the smaller, recurring items. A 3% vacancy allowance against gross rent, a standard way to account for turnover and the odd month without a tenant, adds $900. Add those up and operating expenses total $11,100 for the year.

Net operating income is $30,000 minus $11,100, or $18,900. Divide that by the $650,000 purchase price and multiply by 100, and the cap rate comes out to roughly 2.9%. Notice what didn’t appear anywhere in that calculation: no mortgage payment, no interest rate, no down payment size. Change any of those financing details and the cap rate on this exact property stays at 2.9%, because none of them are part of the formula.

Why GTA cap rates tend to run lower than other markets

If you’ve compared notes with an investor in a smaller Canadian city, or especially in parts of the United States, a Toronto-area cap rate often looks thin by comparison, and the structural reason is straightforward rather than mysterious. A cap rate is NOI divided by price, and Toronto and the surrounding GTA combine some of the highest purchase prices in the country with rents that, while high in absolute dollar terms, haven’t risen at the same pace as purchase prices over the past several years, the general relationship CMHC’s own Rental Market Report tracks through average rents and vacancy by submarket. Push the denominator of that formula up faster than the numerator and the resulting percentage comes down, independent of anything about how well a specific building or unit is run.

That relationship cuts both ways. A lower cap rate in a market like the GTA has historically gone hand in hand with properties that hold and appreciate in value more reliably than markets where you can buy a much higher cap rate but take on more price volatility or weaker long-term demand. Cap rate measures income return in a given year. It says nothing on its own about appreciation, the other half of a real estate investment’s total return.

What a cap rate leaves out

A cap rate ignores financing and leverage entirely. It also ignores appreciation, the change in a property’s own value over time. A property with a modest 3% cap rate that appreciates steadily can easily outperform, on total return, a property with a flashier 7% cap rate in a market where values are flat or falling. Neither number alone tells you which property is the better investment; they’re measuring two different things, and a serious comparison has to look at both.

It also treats every dollar of income the same regardless of how reliable that income is. A cap rate built on a rent roll of long-term, reliable tenants in a stable building isn’t the same quality of 3% as a cap rate built on an assumed market rent that depends on turning over a unit and re-renting it at a higher number. Two properties can share an identical cap rate on paper and carry genuinely different risk. A low cap rate doesn’t automatically mean a bad investment, and a high one doesn’t automatically mean a good one; it’s one input, read alongside the building, the tenant base and your own plans for the property, not a verdict on its own.

The 1% rule and the gross rent multiplier

Two faster, rougher tools come up constantly alongside cap rate, and each earns its place for speed, not for accuracy. The 1% rule asks whether monthly rent equals at least 1% of the purchase price; on the $650,000 property above renting for $2,500 a month, that’s 0.385%, well short of 1%, which is typical of a lot of the GTA rather than a flag that something’s wrong with that specific property. It’s a screening tool meant to flag a property worth a closer look in one direction or another in seconds, built for markets where prices and rents sit in a different relationship than Toronto’s.

The gross rent multiplier, or GRM, is purchase price divided by annual gross rent, with no expenses involved at all. On the same property, $650,000 divided by $30,000 in annual gross rent gives a GRM of about 21.7, meaning the purchase price is roughly 21.7 times a single year’s gross rent. A lower GRM generally points to a property generating more rent relative to its price. Both shortcuts get you a number in seconds precisely because they skip the expense side of the calculation entirely. Neither accounts for property tax, condo fees, insurance or vacancy the way NOI does, so a property can look appealing on the 1% rule or GRM and still carry an operating cost structure that tells a different story once you run the full cap rate.

Frequently asked questions

What is a cap rate and how do you calculate it?

A cap rate, short for capitalization rate, is a property’s net operating income divided by its purchase price, expressed as a percentage. Net operating income is gross rental income minus operating expenses like property tax, insurance, condo fees, maintenance and a vacancy allowance, calculated before any mortgage payment. To calculate it yourself, add up a property’s realistic annual rent, subtract its realistic annual operating expenses to get NOI, then divide that NOI by the purchase price and multiply by 100. A property earning $18,900 a year in NOI on a $650,000 purchase price has a cap rate of about 2.9%. The formula stays the same whether you’re comparing a condo, a house or a multi-unit building.

Does cap rate include the mortgage payment?

No, and this is the detail that trips up more people than any other part of the calculation. A cap rate is calculated entirely before financing, using only net operating income, which already excludes both the interest and the principal portion of a mortgage payment. That means two buyers looking at the exact same property, one paying cash and one financing most of the purchase at a particular interest rate, arrive at the identical cap rate, because financing choices don’t enter the formula at all. What does change between those two buyers is their cash flow after the mortgage payment, which is a separate calculation from the cap rate and depends entirely on how a specific buyer finances the deal. If you want to know how a specific financing structure affects your monthly numbers, that’s a mortgage-level calculation layered on top of the cap rate, not part of it.

What is a good cap rate for a rental property?

There’s no single number that counts as good everywhere, because a cap rate reflects the relationship between price and achievable rent in a specific market and for a specific property type, and that relationship differs between a condo and a house, and between the GTA and markets where purchase prices sit much lower relative to rent. A cap rate that would look low in a smaller city, or in the parts of the United States where prices are lower relative to rent, can be entirely normal in the Toronto area precisely because high purchase prices push the denominator of the formula up. Treat a cap rate as one data point to compare similar properties against each other in the same market, factoring in how reliable the underlying rent is, rather than as a number with a universal pass-or-fail threshold attached to it.

What’s the difference between a cap rate, the 1% rule and the gross rent multiplier?

All three try to describe a rental property’s return, but they trade accuracy for speed in different amounts. The 1% rule is the fastest and roughest: it just checks whether monthly rent equals at least 1% of the purchase price, with no expenses considered at all. The gross rent multiplier divides purchase price by annual gross rent, again with no expenses factored in, giving you a quick sense of how many years of gross rent the purchase price represents. The cap rate is the slowest to calculate and the most complete of the three, because it’s the only one of the three that subtracts operating expenses, property tax, insurance, condo fees, maintenance and a vacancy allowance, to arrive at net operating income before dividing by price. The 1% rule and GRM are useful for screening a long list of properties quickly; the cap rate is the number to calculate properly before you take any one property seriously.