Should I use purchase price or current market value in the denominator?

Use whichever is relevant to your analysis. To evaluate a potential acquisition, use the asking price (or your intended offer). To assess ongoing yield on a property you own, use current market value — this is called the 'going-in' cap rate vs. the 'current yield.' Many investors track both.

What expense ratio should I assume if I don't have actuals?

A common rule of thumb for single-family and small multifamily rentals is a 40–50% expense ratio (operating expenses as a percentage of gross rent). Use the high end for older properties, high-tax markets, or properties requiring active management. Always seek actual tax bills and insurance quotes rather than relying on rule-of-thumb estimates alone.

What is a proforma cap rate?

A proforma cap rate uses projected or stabilized income rather than in-place income. Sellers of underperforming properties often advertise a proforma cap rate based on market rents, not current leases. Always verify what income and expense assumptions underlie any cap rate you're shown — and build your own from scratch if the numbers look optimistic.

Can I use cap rate to estimate what a property is worth?

Yes. If you know the NOI and the prevailing market cap rate for comparable assets, you can estimate value: Value = NOI ÷ Cap rate. This is how commercial property appraisers establish value and how buyers can quickly judge whether a seller's asking price is reasonable relative to income.

How to calculate cap rate (with a worked example)

What you need before you start

Cap rate requires two numbers: Net Operating Income and property value. NOI is the one that takes real work to get right. Value is either the listing price (for a purchase decision) or a market estimate (for an ongoing yield calculation).

Almost every wrong cap rate has the same cause: the mortgage payment slipped into NOI, or vacancy got set to zero. The sections below walk through each step with a concrete example.

The worked example property

A 1,400 sq ft three-bedroom single-family home listed at $285,000. Comparable rentals in the neighborhood rent for $2,100–$2,200 per month.

Step 1: Estimate gross annual rental income

Use the market rent midpoint: $2,150/month × 12 = $25,800 gross annual rent.

If the property is currently leased, use the actual lease amount — but note whether it is at, above, or below market, and what the gap tells you about the first renewal.

Step 2: Build the NOI

Expense category	Annual estimate
Gross rental income	$25,800
Vacancy allowance (6%)	−$1,548
Property taxes	−$3,200
Insurance	−$1,400
Property management (9% of collected rent)	−$2,183
Maintenance and repairs	−$2,000
Net Operating Income	$15,469

Effective gross income after vacancy is $24,252. Total operating expenses are $8,783. NOI = $15,469.

Note what is not here: there is no mortgage payment, no loan amortization, and no capital expenditure line. Cap rate excludes all of those.

Step 3: Calculate cap rate

Cap rate = $15,469 ÷ $285,000 = 5.43%

Expressed differently: for every dollar invested in this property (as if bought with cash), it generates approximately 5.43 cents of net income annually.

Step 4: Interpret the result

A 5.43% cap rate is meaningful only in context. In this market:

Benchmark	Cap rate
Subject property	5.43%
Local market average (similar asset class)	5.0–5.5%
10-year Treasury yield (opportunity cost)	~4.5%

The property is roughly in line with market pricing for its asset class. It is not a deeply undervalued deal — but at a spread of roughly 90 basis points over the risk-free rate, it may still make sense depending on rent growth assumptions and long-term appreciation.

If the market average cap rate were 6.5%, you’d know this property is priced at a premium — either the seller sees something in the rent growth that isn’t yet captured in the numbers, or the property is simply overpriced.

Using the formula in reverse

Once you know the local market cap rate, you can back into a fair value for any property:

Implied value = NOI ÷ Market cap rate

For the same property: $15,469 ÷ 0.055 (5.5% market cap rate) = $281,255

The asking price of $285,000 is roughly in line. If the market were pricing at 6%, the implied value drops to $257,817, about $27,000 under the asking price.

Run this by hand a dozen times and an overpriced listing jumps out before you finish reading the description.