Capitalization rate (or "Cap Rate") is a real estate valuation measure used to compare different real estate investments. Although there are many variations, the cap rate is generally calculated as the ratio between the annual rental income produced by a real estate asset to its current market value.
Real estate investments compete with other assets (e.g. stocks and bonds) for investment dollars. If the opportunity cost of capital is too high, investors will use their capital to purchase other assets and the resulting decreased demand will drive prices down and cap rates up. If the inverse is true, cap rates will be driven down by the increased demand stemming from lower opportunity cost of capital.
The primary source of income in real estate is rent. Rental rates are driven by a variety of supply and demand factors which make up a separate market for rentable space. As investors consider an acquisition, they must project future movements of this market as it relates to the specific asset. If the market is expected to yield future increases in rental rates, investors will pay a higher price for the current income stream, pushing the cap rate down. If the market projects a weak outlook, investors will want to pay less, and cap rates will rise.