Investment Activity and Cap Rates

While investment activity has been slow this year, transaction volumes are expected to increase as interest rates decline from late this month through the year’s end. The federal funds rate is projected to decrease by 1.0% to 1.5% this year, with further reductions of 1.5% to 2.0% anticipated by 2025. This downward trend in interest rates is likely to drive a corresponding decrease in overall capitalization rates.

Cap Rates

For high-demand Class A properties, excluding office buildings, in Sunbelt growth markets, cap rates are expected to average between 5.0% and 6.0%, while Class B properties in these markets may see rates between 6.0% and 8.0%. Class A/B office buildings in major markets are projected to average cap rates of 6.5% to 8.0%, whereas office buildings in high-crime urban markets could experience higher cap rates, ranging from 8.0% to 10%.

The capitalization (cap) rate on a property can be calculated in two primary ways. The first method involves dividing the property’s proforma net operating income (NOI) by its purchase cost or current market value, yielding the actual dollar cap rate. The second approach uses a cap rate formula that factors in the risk-free rate, a risk premium, and the growth rate in rents.

In this formula, the risk-free rate is typically the yield on the 10-year U.S. Treasury Note, which is projected to decline from the current 3.9% to around 2.75% by the summer of 2025. The risk premium, historically ranging between 3.0% and 10.0%, it is estimated to be approximately 7% today, according to Joesph J. Ori.

If the average growth rate in rents is assumed to be 2.5%, the cap rate formula for mid-2025 will produce an average cap rate of 7.25% (2.75% + 7.0% – 2.5% = 7.25%). This is a baseline figure, which must be further adjusted based on the specific location and property type to reflect more accurate market conditions.

The Big Picture

There remains over $200 billion in capital available within commercial real estate (CRE) private equity funds, positioning lenders to be increasingly eager to expand their loan portfolios with new CRE loans. Foreign investors are also expected to remain active in the market, though their involvement may be limited by weaker economic conditions in their home countries and the rising value of the U.S. dollar, which could impact their investment capacity.

As previously reported, Albuquerque continues to see high demand for purchasing. There are both owners/users as well as investors who are seeking real estate to occupy and invest because they continue to see the value in owning real estate. There is a significant amount of cash available in the pockets of buyers and local lenders are reporting their pipelines are full. If you are seeking to either sell or buy commercial real estate in Albuquerque, now is a great time to transact.