In a lot of ways, it’s a seller’s market.

Multifamily communities have been selling like hotcakes, and by all accounts, the market is set to outdo itself again in 2013.

The volume of apartment transactions has expanded annually for the past three years, after hitting a trough of $14.9 billion in 2009. By the end of the third quarter, $47 billion in multifamily assets had changed hands in 2012, on pace to easily eclipse last year’s $53.9 billion.

While these figures speak to the overall health of the market, this expansion may not be good news for buyers. New and old money continues to circle over the sector, from smaller, local players and national institutions alike, as bargain-hunting investors increasingly chase yield off the beaten path. The competition gets a little steeper with each passing day.

The apartment market’s recovery was led by Class A properties in major metros. But just like Yogi Berra said, “Nobody goes there anymore because it’s too crowded.” With so much interest in the cream of the crop, a trickle-down has occurred and will accelerate in 2013.

“We are already seeing more money go into secondary markets, and my guess is that’s going to start pushing cap rates down and closing the gap between secondary and primary markets,” says John Sebree, director of the National Multi Housing Group at Calabasas, Calif.–based Marcus & Millichap.

The same goes for Class A assets versus Class B and C deals on a national basis. “That gap is starting to close as well,” Sebree says, “and I anticipate over the next 18 months, it’ll continue to close.”

It’s not just established apartment veterans set to ante up and push cap rates down. Many multifamily virgins, enamored of the industry’s stellar prospects, are jumping in and inflaming the bidding wars.

“There are more cash buyers out there, which is creating even greater competition,” says Armand Brachman, co-managing partner at Plymouth, Minn.–based owner and developer Dominium. “The seller is going to have to be more careful who he sells to, to make sure they can deliver.”

And in such a frothy environment—where sometimes the numbers do lie—the buyer, of course, is going to have to be careful too.

The Signal and the Noise

For years, the risk premium—the difference between the 10-year Treasury rate and a capitalization rate—has been a bellwether for investors, a shining beacon that steers them to higher yields.

It’s the space where fortunes are made or lost, a calculation to boost a buyer’s confidence before taking the plunge.

Simply put, the bigger the gap between Treasury and cap rate, the better the deal. At the height of the last upturn, in late 2006 and early 2007, the average risk premium was a paltry 90 basis points (bps). Compare that with the long-term historical average of 300 bps and you get a glimpse of just how ridiculously overheated the industry was six or seven years ago.

Right now, the premium is at a healthy 460 bps. For investors, that figure is a big green light, a signal that returns are ripe for the picking, the starting gun of a horse race. But hold your horses. These are strange times.

Nobody ever thought the 10-year Treasury could go below 2 percent, and it’s been beneath that threshold consistently since late April. Through federal monetary policy—quantitative easing and Operation Twist—the Treasury Department continues to artificially deflate interest rates. The operative word here is “artificially.”

As a baseline for measuring risk, can today’s rates be trusted? Are cap rates also artificially deflated? And is the risk premium, that relationship between the 10-year Treasury and cap rates, still a trusted adviser today, as it has been for the past half century?

This federal monetary policy also calls into question a few other tried-and-true metrics. Rents seem to rise when inflation comes, and fall with deflation, yet for the past two years, the multifamily industry has seen the opposite dynamic. And when inflation inevitably does come, it’s hard to believe that rents will rise in lockstep, given how much they’ve risen already.

So today’s artificial interest rates can skewer whether or not you enter a deal, how you project rent growth, and, of course, the time line for selling an asset. For anyone considering an acquisition in 2013, the biggest question is, how do you underwrite an exit? How do you approach exit cap rates?

“The Fed is going to leave interest rates at very low levels for the foreseeable future, because there are very few arrows left in the quiver to help the economy at this point in the cycle,” says Ryan ­Severino, chief economist at New York–based market research firm Reis. “But what they will absolutely do, when the economy is on more solid footing, is they are going to raise interest rates in a very dramatic ­fashion.

“If you don’t think that kind of interest-rate expansion is going to have an effect on cap rates, all I would say is, be very cautious,” ­Severino says.

Geography is Destiny

For Dominium, as with many investors, it’s all about finding that hidden gem. The firm specializes in seeking out value-add opportunities across the South and Midwest and believes that cap rates will remain fairly static in 2013—somewhere in the 6 percent to 8 percent range for rehab candidates in markets like St. Louis, Minneapolis, and Phoenix.

If you ask Jay Olander, CEO of Richmond, Va.–based Landmark Apartment Trust of America (LATA), he’ll tell you that the South is where all the hidden potential lies. Cities in the Texas multifamily market are at the top of LATA’s wish list.

“The largest potential growth corridors we see right now are in places such as Dallas, Houston, and San Antonio,” says Olander. “And there are some Florida markets that have been depressed on the housing side but are still very appealing in terms of rents.”

This jibes with our nation’s migration trends—seven of the country’s 10 fastest-growing metros are below the Mason-Dixon line.

Olander adds that there isn’t really any market out there that will have an abundance of supply yet, but he thinks there will be less competition in 2013 in Southern markets for A and B products since so many investors are concentrating on the coasts.

But Dominium and LATA are certainly not alone. As of the end of the third quarter of 2012, the transaction market in St. Louis was up 45 percent year over year, Minneapolis saw 37 percent growth, and the Texas markets of Dallas, Houston, and San Antonio each saw transaction volume climb more than 16 percent in 2012.

One REIT that specializes in secondary Southern markets is Memphis, Tenn.–based MAA. And while the company is concerned about all the new development going on in some of its favorite metros, it believes that job and rent growth will mitigate the impact.

“Markets like Austin and Raleigh are expected to be high job-growth markets,” says Tim Argo, senior vice president and director of financial planning for MAA. “Although there will be new supply, there will also be enough demand to offset that.”

Argo says there is potential for these secondary markets to start outperforming larger metros by late 2013 or early 2014, as rent growth slows in the nation’s primary markets.

REO to Rent

Another burgeoning investment opportunity lies in the REO-to-rental market.

Firms such as Waypoint Homes, Builders of Hope, and American Residential Properties (ARP), have been busy over the past year buying up pools of foreclosed homes from lenders and turning them into rental properties with unique leasing structures. Sometimes it is a two-year lease with an option to own, and sometimes it’s a custom structure, but the aim is to minimize turnover.

How feasible is this market, and what are the chances of the business model lasting through the next housing cycle? Longevity isn’t exactly the point, says Doug Brien, co-founder of Oakland, Calif.–based Waypoint, which has acquired 1,800 homes since 2008.

“We can just sell the homes and still make a profit if homeownership does start to go back up and Renter Nation collapses,” he says. Brien acknowledges, however, that there are many challenges unique to this asset class, particularly the scattered-site nature of such a portfolio. It requires a good deal of manpower and boots on the ground to make this type of investment pay off, he says.

There are other critical factors, too. Laurie Hawkes, president of Scottsdale, Ariz.–based ARP, says no two properties are the same and that, often, each needs to be treated individually.

“Family circumstance plays the biggest role in our business,” says Hawkes. “You can expect to see 20 to 25 percent turnover on these properties, lower than traditional multifamily. It is very important that you have an intimate knowledge of each local market.”

The market will likely expand in 2013, as Fannie Mae, Freddie Mac, and the FHA look to unload vast portfolios on the market.

Build versus Buy

As cap rates shrink across the nation, the yields that can be achieved with new construction become more attractive—and that’s exactly what Dallas-based Stratford Land is banking on. The company has been on a buying spree the past five years, acquiring $700 million worth of land, often at distressed prices. And according to Stratford’s chief risk officer, Mark Drumm, the company is extremely confident that it will have no shortage of multifamily buyers.

“The next year is a great time for us to sell some of our land to developers looking to bring new units to market,” says Drumm, particularly in Phoenix, Texas, Southern California, and Florida.

For all those acquirers out there—of both buildings and land—­caveat emptor. Yes, the demographics are great, and, yes, it’s a good time to buy and build. But given the uncertainty in the capital markets, it may not be as good a time as the numbers indicate.