The capitalization (cap) rate is the return you would receive on an investment property if you paid cash for it. It’s a metric to compare the investment potential in real estate vs. some other type of investment, like stocks or equities.

It’s calculated by dividing the net operating income (rent you receive minus expenses such as taxes, maintenance fees and repairs) by the purchase price of the unit.

For example, if you wish to purchase a 1-bed condo in the Mount Pleasant area of Vancouver at a purchase price of $400,000, you could rent it out at $1,400 per month. Your net operating income for the year would be $16,800. With maintenance fees of $275 per month, contingency repairs of $1,000 on an annualized basis, $1,400 for property tax, your total expenses for the year would be approximately $6,000. Take your annual expenses less your net operating income and you are left with approx $10,800 net rental income.

To calculate the cap rate, take the purchase price of $400,000 and divide it by the rental income of $10,800, giving you a cap rate of 2.7%. Remember, that is assuming you are paying for this condo in cash. You are not taking out a mortgage.

We all know you would be crazy to buy an investment property in cash only. The magic with real estate is the use of controlled leverage. You would put 20% down of your own money and borrow the remaining 80%. The interest would then become deductible, taking advance of leverage.

The cap rates for Lower Mainland properties tend to be lower than many other North American cities due to the high purchase price. However, a city like Vancouver makes up for it with superior price appreciation or capital gains over time. And remember; only 50% of the capital gain will be taxable in your marginal tax rate when it comes time to sell the property.