Real Estate Downturns: How to Read the Market’s Signals (Cap Rates Explained)

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If you've been following me for a while, you know I'm a huge fan of the cap rate reports put out by companies like Colliers & CBRE. These reports are more important now than ever.

When real estate markets turn rocky, smart investors turn to data. In a market crash or downturn, understanding key metrics can mean the difference between panic selling and seizing opportunities. One of the most important metrics is the capitalization rate, or cap rate – and a seemingly small change in this number can signal big shifts in property values and risk.

What Is a Cap Rate and Why Does It Matter?

A cap rate is essentially the annual return on a property if you bought it with cash – the ratio of a property’s net operating income (NOI) to its value. For example, a building with $50,000 NOI worth $1 million has a 5% cap rate. It’s a quick way to gauge yield: higher cap rate = higher return (but often higher risk or lower growth expectations), while lower cap rate = lower return (often for “safer” assets or hot markets).

Here’s why investors obsess over cap rates: small cap rate moves translate to huge value changes. Property value is NOI ÷ cap rate, so if the cap rate rises, value falls. As one investor pointed out, going from a 4% cap to 6.5% cap “is not just a 2.5% move – it’s a 38.5% crash in value… put 30% down? You’re completely wiped out.” In other words, a property yielding $100k in NOI was worth $2.5 million at a 4% cap, but only ~$1.54 million at 6.5%. That drop could erase all equity for a highly-leveraged owner. Understanding this math is crucial – cap rates are a market thermometer, and a few percentage points can swing values by 20, 30, 40% or more.

Cap Rate Compression vs. Expansion (Boom vs. Bust)

When the market is booming, cap rates tend to compress (fall). Investors accept lower returns for real estate, which pushes prices up. This cap rate compression often happens when interest rates are low, capital is cheap, and optimism is high. A textbook definition: “cap rate compression – falling cap rates – happens when market conditions are strong and generally leads to rising real estate values.” In the 2010-2019 expansion, for instance, cap rates steadily declined in many markets, boosting property values dramatically.

During downturns, we see the opposite: cap rate expansion – rising cap rates – happens when conditions are poor or uncertain, leading to falling property prices. Essentially, the market demands a higher yield to compensate for higher risk or financing costs. Historically, cap rates shot up in recession periods like 2008-2009, when property values fell and only bargain hunters were buying. One analysis of U.S. data shows cap rates falling in the 2002–2006 boom, then rising substantially from 2007–2010 during the Great Recession, before falling again in the recovery. The same pattern holds in Canada and other markets: booms bring cap rates down, busts push them up as investors switch from greed to fear.

Watch the “Cap Rate Spread” (Yield vs. Bonds)

Real estate doesn’t exist in a vacuum – investors compare it to other investments like bonds. The cap rate spread is the difference between the property cap rate and the 10-year government bond yield, and it serves as a risk premium indicator. Historically in Canada, investors have wanted about a ~4% higher yield on real estate over 10-year government bonds. If the 10-year bond is 3%, a “normal” market might have around a 7% cap rate on average, which is a 4% spread compensating for real estate’s risk and illiquidity.

In frothy markets, this spread narrows – cap rates get very low relative to bonds.

For example, in 2021, interest rates were near record lows and optimism was high. Prime multifamily buildings in cities like Vancouver and Toronto traded at cap rates in the low-3% range, even as 10-year bond yields climbed above 3%. That meant in some cases the cap rate spread went to zero or even negative (e.g. a 3.5% cap vs a 3.7% “risk-free” bond). Such a negative cap rate spread signals an overheated market – essentially betting on future rent growth or price appreciation to justify a low yield.

In downturns, the opposite happens: investors get cautious and the spread widens. Either cap rates jump, or bond yields fall, or both. During the 2008-09 crisis, 10-year yields dropped while real estate cap rates spiked, creating a very wide spread (properties had to yield much more to attract any buyers). We saw a version of this in 2022-2023: interest rates rose sharply, and cap rates also pushed up because buyers demanded better returns.

By late 2023, the average cap rate in Canada had increased to around 6.5%, while the 10-year bond yield was ~3.1%, giving about a 3.4% spread – back in a more normal range.

Figure: Canadian cap rates vs. 10-year bond yields over time. In boom periods (mid-2000s, late-2010s), cap rates (colored lines for different asset classes, with blue dashed average) compressed, coming closer to the low bond yields (gray line). In recessions (2009 and 2022-23), cap rates expanded upward even as bond yields fell or stayed low, widening the spread. As of Q1 2025, the average cap rate was ~5.87% while the 10-year bond was ~3.12%, a 2.75% spread – slightly below the ~4% long-term average risk premium.

What’s Happening Now in Canada (2023-2025)

After years of ultra-low interest rates, the tide turned in 2022. The Bank of Canada’s rapid rate hikes slowed the market, and cap rates began rising from their record lows. Property values adjusted downward as a result. For example, multi-family apartment cap rates in Toronto and Vancouver, which were in the ~3% range in 2021, have moved into the 4%–4.5% range by mid-2024. That corresponds to roughly a 15–20% drop in theoretical values (partly cushioned by rising rents). In cities like Calgary, cap rates went from around 5% to ~5.5%, and in Halifax from about 5% to the 5.5–6% range.

These higher cap rates mean better income yield for new investors today compared to the 2021 market peak, reflecting both higher financing costs and a return of risk aversion. Nationally, the overall cap rate has leveled off around 5.9% in early 2025, after climbing throughout 2022-23. Importantly, cap rate trends have varied by asset type: for instance, suburban apartment yields rose into the mid-4% range on average, whereas downtown office yields skyrocketed into the high single-digits as that sector struggled.

The good news: as of 2024-2025, it appears cap rates have stabilized in many markets. Buyers and sellers are finding a new equilibrium with the higher interest rates. In fact, investor surveys show renewed interest in markets like Vancouver and Halifax (top-ranked for their stability and growth prospects). Should interest rates start to ease, we might even see cap rates compress slightly again, which would boost values for those who bought during the high-cap-rate period.

Key Takeaways for Investors

• Cap rates are crucial in a downturn: They distill market risk and pricing in one number. Track cap rate moves in your target markets; rising cap rates mean prices are falling (potential opportunity if you have capital), while falling cap rates mean prices are bid up (greater risk of overheating).

• Mind the gap (spread): Compare cap rates to interest rates. If property yields are lower than the cost of debt or bonds, be cautious – the market is priced for perfection with little margin for error. A healthy spread (e.g. cap 6% vs bond 3%) indicates more cushion and potentially better value.

• Stress-test with cap rate expansion: Don’t assume today’s cap rate will hold. Underwrite deals with a higher “exit cap rate” (e.g. if buying at 5%, model selling at 6%+) to see if the investment still makes sense. This conservative approach can protect you from overpaying. Deals that only work if cap rates keep compressing are recipes for trouble – as one expert said, those pro formas “should go right in the garbage.”

• Leverage carefully: In a downturn, high leverage can wipe you out if values tumble. If you bought at a 4% cap with 80% debt, a cap rate jump to 6% could erase your equity. Keep loan-to-value ratios at prudent levels and have cash reserves to ride out storms.

• Look for upside in tough times: Ironically, a market crash can be the best time to buy – if you have a long-term view. Higher cap rates mean lower prices and higher income. Just ensure the property’s fundamentals (location, occupancy, rent prospects) are solid. When the cycle turns and cap rates compress again, those who bought at high cap rates stand to gain the most in value appreciation.

In summary, real estate downturns are challenging, but they also “reset” the playing field. By tracking metrics like cap rates and spreads, investors can cut through the noise of headlines and make informed decisions. A spike in cap rates might spell short-term pain for existing owners, but it can open the door for savvy buyers to acquire assets at a relative discount. And when the market eventually recovers (as history shows it always does), those metrics will swing back. If you learn to read the signals – and act with prudence – a rough market can become an opportunity rather than a setback.