Dividend Discount Model

The dividend discount model values a stock as next year's dividend divided by the required return minus the dividend growth rate. Applied to property, it is the theory behind the cap rate: value equals next year's NOI divided by (discount rate minus NOI growth), so cap rate equals discount rate minus growth.

The Gordon growth form of the model explains the two things that move cap rates. A higher required return, from higher interest rates or more perceived risk, raises the cap rate and lowers value. Higher expected growth in NOI lowers the cap rate and raises value.

It also explains why a low cap rate is not necessarily a bad investment. A 4% cap rate with 4% expected NOI growth implies the same 8% total return as an 8% cap rate with no growth. The buyer at 4% is paying for growth in advance and bearing the risk that it does not arrive. The model assumes growth is steady forever, which property never delivers, but the direction of the relationships holds.

Further reading: Dividend Discount Model on Wikipedia.