Key Points:

• Multifamily cap rates appear poised to decline for the first time in nearly two years.
  
  
• Using First American’s Multifamily Potential Cap Rate Model, we forecast that multifamily cap rates are likely to gradually decline throughout 2025. 
  
  
• The return of declining cap rates would be a sign that buyers are becoming more comfortable with existing yields and stepping back into the market in earnest. 
  
  
• Falling multifamily cap rates in 2025 will be a sign of growing investor demand to own apartment buildings.

With 2024 now behind us, it’s time to look ahead to the new year. At first glance, 2025 appears to offer reasons for cautious optimism, a sentiment that was not widely shared a year ago. Much of this stems from the onset of the Federal Reserve’s rate-cut cycle. Additionally, the moderation in multifamily price declines suggests that the bulk of the market correction is likely behind us.

A notable difference between the start of 2024 and 2025 is that multifamily cap rates now seem to be at an inflection point, poised to decline. In contrast, a year ago, they were still on the rise with no clear end in sight. Falling cap rates, which translate to increasing valuations, will be a rising tide that lifts many boats in the multifamily market in the new year.

“Falling cap rates, which translate to increasing valuations, will be a rising tide that lifts many boats in the multifamily market in the new year.”

A Slight Decline That’s Sort of a Big Deal

In a prior post, we anticipated that multifamily cap rates would stop increasing and reverse beginning in the third quarter of this year. This reversal technically occurred, just not at a level of real significance (from 5.72 percent in the second quarter to 5.68 percent in the third). Still, many will view even this small decline as a big deal given it’s the first time multifamily cap rates have fallen since the first quarter of 2022. In other words, multifamily cap rates appear to have stalled, and there is growing downward, rather than upward, pressure. 

How far might multifamily cap rates fall in 2025? To answer this question, we used First American’s Multifamily Potential Cap Rate (PCR) Model to forecast multifamily cap rates through the end of 2025. The Multifamily PCR Model uses sales transaction volume, multifamily debt flows¹, and renter household formation as inputs to compute a “potential” multifamily cap rate, which is then used to estimate a forecast. The forecast assumes that multifamily sales volumes increase by approximately 20 percent in 2025 compared to 2024, that debt flows continue to gradually decline as debt is paid down to offset higher interest rates, and that renter household formation moderates, but remains positive.

The multifamily PCR model estimates that multifamily cap rates will gradually decline throughout 2025 from 5.7 percent, where they were in the third quarter, to 5.2 percent by the end of this year. The last time multifamily cap rates were below 5.2 percent was in the first quarter of 2023, less than a year into the price adjustment. A 0.5 percentage point decline in cap rates would equate to roughly an 8.5 percent increase in multifamily valuations, holding income equal. 

Falling Cap Rates a Sign of Purchase Demand Returning

Since cap rates measure market yield and are largely determined by the demand for commercial properties, the onset of falling multifamily cap rates signals a genuine return of purchase demand to the market. Investors are gradually becoming more willing to accept slightly lower property-level returns² to secure desirable investments. This trend also indicates that investors are less fearful of future multifamily price declines and are willing to embrace some near-term uncertainty to remain active in today’s market at prevailing prices.

Of course, these trends are national averages, and city-specific cap rates will be determined by local supply and demand fundamentals. Specifically, in the new year, there will be significant  attention paid to the substantial quantity of new apartment supply coming to market across the country and whether there will be sufficient leasing demand to absorb these new units. Cities with lots of new apartments coming to market that lack leasing demand will see softer rents, which would dampen demand to purchase apartment properties in some locations, at least in the near term. 

Still, at a national level, a reversal in multifamily cap rates is at hand, and this will provide a valuation tailwind to the multifamily market in 2025 that was absent in 2024.

Third Quarter 2024 Multifamily Potential Cap Rate Model

• The multifamily PCR was 5.2 percent, an increase of 0.1 percentage point as compared with the first quarter of 2024.
  
  
• The multifamily PCR increased by 0.2 percentage points as compared with one year ago.

Multifamily Cap Rate Outlook Gap

• The actual multifamily cap rate was 0.5 percentage points higher than the multifamily PCR, which suggests that market fundamentals in the third quarter supported lower multifamily cap rates than were observed. 
  
  
• The gap between the actual multifamily cap rate and the multifamily PCR increased by 0.1 percentage points in the third quarter of 2024 as compared to the second quarter of 2024.  

About the Multifamily Potential Cap Rate Model 

The multifamily Potential Cap Rate (PCR) Model estimates cap rates based on the historical relationship between multifamily transaction volume, annual changes in renter household formation, and multifamily mortgage flows. The multifamily PCR Model uses these metrics to establish a potential cap rate level that is supported by these market fundamentals. When actual multifamily cap rates are significantly above the multifamily PCR, it indicates that market fundamentals supported lower cap rates than were observed. Conversely, when actual cap rates are significantly below the potential cap rate level, market fundamentals supported higher cap rates than were observed. Multifamily cap rates are aggregated nationally, and the PCR Model is updated quarterly.