What is true regarding the relationship between cap rates and property value?

The relationship between cap rates and property value is fundamentally grounded in the income approach to valuation. A cap rate, or capitalization rate, is derived from the net operating income (NOI) of a property divided by its current market value. When cap rates are higher, it means that the property is generating a relatively higher return compared to its value, which usually occurs when either the property is perceived as risky or the market is less favorable.

In this context, higher cap rates generally suggest that the property is valued lower in the market. Investors demand a higher return to compensate for the perceived risks associated with the investment, leading to a decrease in property value. Conversely, a lower cap rate indicates that a property is valued higher because it is generating a lower return relative to its price. This lower return generally suggests less risk or the property being in a more desirable location, leading to higher valuations.

Understanding this relationship helps investors make informed decisions about property purchases, sales, and overall market trends.