Cap Rate vs Mortgage Rate: When a Commercial Deal Actually Makes Sense

# Cap Rate vs Mortgage Rate: When a Commercial Deal Actually Makes Sense

Every commercial real estate investor eventually faces the same fundamental question: does this deal actually make money, or am I just buying a problem? The answer almost always comes down to the relationship between two numbers - the capitalization rate and the mortgage rate.

Understanding this relationship is the difference between building wealth through commercial property and slowly bleeding cash every month.

What Is a Cap Rate?

The capitalization rate (cap rate) measures the return a property generates based on its income, independent of financing. It's calculated as:

Cap Rate = Net Operating Income (NOI) / Purchase Price

For example, a property that generates $120,000 in NOI and is priced at $2,000,000 has a cap rate of:

$120,000 / $2,000,000 = 6.0%

The cap rate tells you: "If I paid all cash for this property, what would my annual return be?"

Cap rates vary significantly by property type and market. Here are typical ranges across Canada:

Source: CREA, Commercial Property Trends Report, 2024

Source: Altus Group, Canadian Cap Rate Survey, Q4 2024

Lower cap rates generally indicate lower risk and higher property values. Higher cap rates suggest higher risk or less desirable markets - but also higher potential returns.

What Is a Mortgage Rate?

The mortgage rate is the cost of borrowing. In commercial real estate, this is typically expressed as the mortgage constant - the annualized total debt service as a percentage of the loan amount.

For a typical commercial mortgage:

• Interest rate: 5.50%–6.50% (5-year fixed, conventional, 2024–2025)
• Amortization: 25 years
• Mortgage constant: Approximately 7.0%–7.8%

Source: Bank of Canada, Selected Bond Yields and Interest Rates, 2025

The mortgage constant is higher than the interest rate because it includes principal repayment. This is the number you should compare to the cap rate.

Positive vs Negative Leverage

Here's where the magic - or the trap - happens.

Positive leverage occurs when the cap rate exceeds the mortgage constant. The property earns more than the cost of debt, and leverage amplifies your returns.

Negative leverage occurs when the mortgage constant exceeds the cap rate. Every dollar you borrow actually reduces your returns compared to buying all-cash.

Example: Positive Leverage in Action

• Purchase price: $2,000,000
• NOI: $140,000 (cap rate: 7.0%)
• Mortgage: $1,500,000 at 5.75%, 25-year amortization
• Annual debt service: $108,000 (mortgage constant: 7.2%)

Wait - 7.0% cap rate vs 7.2% mortgage constant. That's actually slightly negative leverage! But the cap rate only tells part of the story.

Your cash-on-cash return (the return on your actual equity invested) is:

Cash flow before tax = $140,000 – $108,000 = $32,000

Equity invested = $500,000 (plus closing costs ~$25,000) = $525,000

Cash-on-cash return = $32,000 / $525,000 = 6.1%

That's before accounting for principal paydown, tax advantages, and potential appreciation. The total return picture may still be compelling even when simple cap-rate-to-mortgage-constant math looks tight.

Example: Negative Leverage Destroying Value

• Purchase price: $3,000,000
• NOI: $135,000 (cap rate: 4.5%)
• Mortgage: $2,250,000 at 6.25%, 25-year amortization
• Annual debt service: $176,000 (mortgage constant: 7.8%)

Cash flow before tax = $135,000 – $176,000 = –$41,000

You'd be losing $41,000 per year in cash flow. You're subsidizing the property out of your own pocket and betting entirely on appreciation. This is speculation, not investment.

The Spread: Your Margin of Safety

Sophisticated investors focus on the spread between the cap rate and the mortgage constant. A healthy spread provides a cushion against rising rates, unexpected vacancies, and operating cost increases.

Source: Bank of Canada, Financial System Review, 2024

In the current interest rate environment, finding properties with a 150+ basis point positive spread requires looking beyond major urban centres and into secondary markets, value-add opportunities, or properties with below-market rents.

Use our mortgage calculator to model specific scenarios.

When Negative Leverage Can Still Work

Negative leverage isn't always a deal-breaker. There are legitimate strategies that justify accepting it temporarily:

1. Below-market rents with upside: If current rents are 20–30% below market and leases are expiring soon, the cap rate will improve as you bring rents up.

1. Value-add renovation: A property in poor condition may have a low cap rate today but a significantly higher one after capital improvements.

1. Development potential: Land value or redevelopment potential may justify a lower current yield.

1. Interest rate decline: If you believe rates will fall at renewal, negative leverage may reverse. But betting on rate declines is risky.

In each case, you need a clear, executable plan to move from negative to positive leverage within a defined timeframe.

When to Walk Away

Walk away from a commercial deal when:

• The cap rate is below your mortgage constant and you have no realistic plan to increase NOI
• The cap rate is compressed due to unrealistic pro-forma projections rather than actual income
• The seller's asking price only works with assumptions that are wildly optimistic
• You're relying entirely on appreciation with negative monthly cash flow
• Stress testing a 2% rate increase at renewal puts DSCR below 1.0x

The best commercial investors are disciplined about walking away. There will always be another deal.

How to Analyse a Deal in 5 Minutes

Here's a quick framework for initial screening:

1. Calculate the cap rate using actual (not projected) NOI
2. Estimate your mortgage constant based on realistic rate and amortization
3. Compute the spread: cap rate minus mortgage constant
4. Check your DSCR: NOI divided by annual debt service (target 1.25x+)
5. Calculate cash-on-cash return: annual cash flow divided by total equity invested

If steps 3 and 4 look healthy, it's worth deeper analysis. If not, move on.

Explore your financing options to understand what rates and terms you can realistically achieve before you start shopping for properties.

The Bottom Line

In the current Canadian commercial real estate market, the relationship between cap rates and mortgage rates demands careful analysis. With interest rates still elevated compared to the 2020–2021 period, positive leverage is harder to achieve - but not impossible.

Focus on properties where the fundamentals support positive leverage today, or where you have a clear value-add strategy to get there. And always stress test your numbers against rising rates and higher vacancy.

References

• Bank of Canada, Selected Bond Yields and Interest Rates: https://www.bankofcanada.ca/rates/interest-rates/
• Bank of Canada, Financial System Review: https://www.bankofcanada.ca/publications/fsr/
• CREA, Commercial Property Statistics: https://www.crea.ca/housing-market-stats/
• Altus Group, Canadian Cap Rate Survey: https://www.altusgroup.com/insights/canadian-cap-rate-survey/
• CMHC, Housing Market Information: https://www.cmhc-schl.gc.ca/professionals/housing-markets-data-and-research