Macro Summary
The Federal Reserve ended 2025 with two rate cuts, bringing the federal funds target range to 4.00 to 4.25 percent by December. As of January 2026, the Fed has signaled a pause. Core PCE remained at 2.6 percent through November, above the 2 percent target but no longer accelerating. Labor markets have cooled meaningfully: monthly job adds averaged 98,000 in Q4 2025 versus 180,000 for all of 2024.
The 10-year Treasury yield, which is the more relevant rate for commercial real estate pricing, closed 2025 at approximately 4.45 percent after briefly touching 4.85 percent in October. That spread compression from the October highs has provided modest relief to debt markets, but rates remain materially elevated compared to the 2019 to 2021 period when most sponsor underwriting was formed.
Inflation expectations remain anchored in the 2.2 to 2.5 percent range on a 5-year forward basis. The Fed's current communication is that cuts will be data-dependent, with the next move unlikely before the June 2026 meeting absent a material labor shock. Markets are pricing roughly 1.5 additional 25 basis point cuts by year-end 2026.
The Cap Rate Spread Relationship
Cap rates do not move in lockstep with the 10-year Treasury. Understanding why this matters requires a brief detour into how institutional buyers price commercial real estate.
The "spread" refers to the difference between an asset's cap rate and the risk-free rate (typically the 10-year Treasury). Historically, institutional buyers have required a spread of 150 to 250 basis points over Treasuries for core multifamily assets, more for opportunistic or value-add deals where execution risk is higher.
When rates rose sharply in 2022 and 2023, that spread compressed to near zero or even negative territory in some markets. Buyers were acquiring assets at cap rates of 4.5 to 5.0 percent while 10-year Treasuries sat at 4.0 to 4.75 percent. The premium for illiquidity and operational risk had essentially disappeared.
What happened next is important: transaction volume collapsed. Sellers were anchored to 2021 valuations. Buyers repriced their required returns. The bid-ask spread widened and deals stopped trading.
We are now in the second phase of that correction. As the 10-year has stabilized in the 4.25 to 4.50 range, some sellers have capitulated and accepted lower prices. Cap rates in most major markets have reset 100 to 150 basis points higher than their 2021 lows. The spread over Treasuries is beginning to normalize, which is why transaction volume in Q3 and Q4 2025 was meaningfully higher than the 2023 trough.
Cap rate expansion means asset values decline, all else equal. A multifamily asset generating $1M in NOI priced at a 5.0 cap rate is worth $20M. At a 6.0 cap rate, it is worth $16.7M. That is a 17 percent value decline with no change in income.
Sponsors who acquired in 2020 to 2022 using aggressive cap rate assumptions at exit face this reality when refinancing or selling. LPs in those deals may receive reduced or zero returns even if the asset performed operationally.
What LPs Should Watch in Q1 2026 Deals
The pause environment is neither clearly favorable nor unfavorable. It creates specific conditions worth watching in any deal you are reviewing this quarter.
Exit cap rate assumptions. Any sponsor projecting an exit cap rate materially below current market needs to explain why. If comparable sales in a market are trading at 5.75 percent cap rates and a sponsor's 5-year projection shows an exit at 5.0 percent, they are pricing in cap rate compression that requires either rate cuts beyond current consensus or demand conditions not yet visible in the data. Ask for the sensitivity analysis.
Floating rate debt exposure. Bridge loans originated in 2021 to 2023 with 3-year terms are now maturing into a materially different rate environment. Sponsors who cannot refinance at the original basis may be conducting secondary equity raises to cover the debt service gap. Understand how existing portfolio assets are being managed before committing to new deals with the same sponsor.
Revenue assumptions. Rent growth in most secondary markets has decelerated to 1 to 3 percent annually after the 2021 to 2022 spike. Sponsors still modeling 4 to 6 percent annual rent growth are using assumptions that require a supply shock or demand surge not evident in current market data. Check the submarket-level vacancy trend, not just the headline rent index.
Framework Tip
How to Calculate Implied Cap Rate From NOI and Asking Price
This is the single most useful calculation you can run in under 60 seconds when reviewing a deal deck.
Once you have the implied cap rate, compare it to: (1) recent comparable sales in the same submarket, (2) the current 10-year Treasury plus 200 basis points as a rough institutional floor, and (3) the sponsor's exit cap rate assumption. If the going-in cap rate is lower than the exit cap, the deal's return thesis depends on NOI growth alone. That is achievable. If the going-in cap is also below Treasuries plus 200 bps, you are buying at a premium to institutional pricing, and you should understand why.
Deal Question of the Week
Ask Every Sponsor This Before Reviewing the Pro Forma
"What is your current portfolio occupancy across all active assets, and which deals are underperforming their original underwriting?" The answer tells you more than any projected IRR. Sponsors with assets performing in line with original projections will answer specifically. Sponsors carrying underperforming assets will generalize.
If a sponsor has a deal in the portfolio acquired at a 4.5 percent cap rate with floating rate debt that is now maturing, that is material information before you review a new offering from the same team. Ask. The answer is not disqualifying, but the evasion would be.