Introduction

At the start of this year, cap rates showed signs of compression, especially in multifamily real estate. But does a lower cap rate mean an asset is safer? Or is it just more expensive?

At Forty5Park, we think it's the latter.

Cap rate compression is more than a pricing phenomenon. It's a signal of broader macro shifts: investor sentiment, capital flows, interest rate regimes, and perceived asset safety. If you’re buying or managing multifamily assets today, understanding how cap rate movement impacts value and return is table stakes. Here’s how we look at it.

What Is Cap Rate Compression?

Cap rate = Net Operating Income (NOI) / Property Value. When cap rates fall while NOI stays flat, values rise.

That’s cap rate compression: paying more for the same cash flow.

We saw this across U.S. multifamily from 2010 to 2021. In 2010, average cap rates were around 6.8%. By 2021, they had dipped below 4.5% nationally, with some Sun Belt assets trading in the high 2% to 3% range.

Why?

• Declining interest rates (10-Year Treasury hit ~0.5% in 2020)

• Surging capital inflows from institutions and foreign investors

• Multifamily’s rise as a "core" asset class

• Strong demographic tailwinds and rent growth

It was a perfect storm of liquidity, low yields elsewhere, and optimism.

Cap Rate vs. Risk-Free Rate: The Spread

We always ask: what’s the spread between cap rates and the 10-Year Treasury?

Historically, investors have demanded a 200–300 bps premium over Treasuries for multifamily. In 2021, with cap rates at 4% and Treasuries at 1%, the spread was generous. But by 2023, Treasuries rose to 4% while cap rates lagged—shrinking the spread to near 100 bps in some markets.

That’s risk. If your cost of debt is higher than your yield, you’re in negative leverage territory.

What Cap Rate Compression Actually Means

Cap rate compression does not necessarily mean lower risk. It often means higher pricing risk:

• Investor confidence: People are betting on growth or exit value.

• Liquidity surge: More buyers chasing fewer deals.

• Aggressive underwriting: Assuming low exit caps or high rent growth.

In short, compression tells you what buyers believe about the future—not what the fundamentals guarantee.

How It Impacts Returns

Lower cap = lower yield. That puts more pressure on:

• Rent growth to hit IRR targets

• Terminal cap assumptions

Let’s say you buy at a 4.0% cap and sell at a 6.0% cap. Even with NOI growth, your IRR can drop to near zero. Now flip it—buy at 6.0% and sell at 4.0%—and you’re a genius. That’s how sensitive real estate is to small moves in the cap rate.

Many investors from 2010–2021 enjoyed windfall returns from compression, not necessarily from operations.

What Happens When Cap Rates Expand

Since 2022, cap rates have started climbing again. High inflation, Fed rate hikes, and tighter liquidity have pushed average multifamily cap rates to 5.5–6% in some markets.

Strategies to hedge cap rate expansion:

• Buy below replacement cost

• Underwrite conservative exit cap (+50 to 100 bps)

• Focus on NOI growth (renovations, leasing, ops)

• Fix your debt or cap your interest rate

• Be patient—extend hold period if needed

The most resilient investors in this cycle are those who assumed nothing and focused on cash flow.

Final Thoughts

Cap rate compression isn’t just a pricing shift—it’s a macroeconomic signal. It tells you what markets believe about the future of growth, risk, and liquidity.

But if you’re underwriting with discipline, you shouldn’t need cap rate compression to make a deal work.

At Forty5Park, we model every asset across a full range of cap scenarios—compression, expansion, and flat—and ask: what happens to yield, IRR, and exit value under stress?

That’s how real returns are built.