What is the impact on cap rates when property prices decrease?

When property prices decrease, cap rates typically increase. This relationship between property prices and cap rates is grounded in the fundamental principle of how cap rates are calculated. The cap rate, or capitalization rate, is determined by dividing a property's net operating income (NOI) by its current market value or sales price.

When property prices drop but the NOI remains the same, the formula reveals that the cap rate must increase because you are dividing the constant NOI by a lower denominator (the property value). This increase in cap rate reflects a higher perceived risk or a greater yield requirement by investors, as they demand higher returns when the market value of an asset decreases.

In summary, a decrease in property values leads to an increase in cap rates because the fixed NOI is now being evaluated against a lower property price, thereby resulting in a higher ratio. This shift is indicative of changing market conditions and the dynamics of investor expectations.