Can apartment capitalization rates continue to fall? That’s the question on many finance professionals’ minds as the current pricing environment continues to surprise observers and force multifamily firms to reconsider their investment strategies.

“In many markets around the country, cap rates are approaching all-time lows, once again,” says Dan Fasulo, managing director at New York–based market research firm Real Capital Analytics (RCA). “And despite the recent economic turbulence, I would not bet right now that cap rates are going higher any time soon.”

Yet, few believe that this cap-rate compression trend can last. Just 17 percent of multifamily finance professionals think cap rates will continue to fall in 2012, according to a survey of 138 senior-level decision makers conducted by Apartment Finance Today in August. About 61 percent of respondents see cap rates staying flat next year, while another 22 percent believe rates will rise.

“I don’t think they can fall much more than they are right now,” says Dennis Steen, CFO of Houston-based Camden Property Trust. “We think there’s probably more of a bias for rates going up than for staying at the same levels.”

Still, there’s a perfect storm brewing in the capital markets that should keep cap rates stable over the next six months, if not falling further. The Federal Reserve pledged in August to keep interest rates low for the next two years, and the ever-improving debt market has given borrowers more options and more competitive pricing. Couple that with the multifamily industry’s status as the preferred asset class of most real estate investors today, and you’ve got a formula for low caps.

“I don’t think it’s imminent that rates are going to go up significantly,” says David Gardner, CFO of Rochester, N.Y.–based REIT Home Properties. “I think we’re still looking at a period of time of status quo.”

Anyone’s Guess
The truth is, it’s anyone’s guess where cap rates are heading. Last year, 78 percent of multifamily finance professionals thought cap rates would either rise or stay flat in 2011, and here we are in a falling–cap-rate environment.

Indeed, few saw this coming. The swift pace of cap-rate compression has forced many firms to re-engineer their investment strategies, prompting many firms to redouble their new construction pipelines in a search for greater yields.

Hold periods are also being reconsidered given today’s price tags. For instance, at the beginning of 2011, Highlands Ranch, Colo.–based UDR wasn’t planning on any dispositions this year. Yet the REIT recently updated that forecast significantly and is now marketing between $400 million and $600 million in assets.

The assets that UDR is marketing—in markets like Sacramento, Calif., and Fredericksburg, Va.—speak to a broader recovery. The cap-rate compression that began last year with Class A assets in primary markets has trickled down to B assets and smaller metros, as more investors aggressively chase yield in unexpected places.

“I’ve seen 5-caps in Raleigh-Durham and Austin over the last month,” says Fasulo. “And caps actually below 4 percent in California recently.”

CMBS the Key
Acquisition activity in the multifamily sector is expected to be just over $50 billion this year, up from about $35 billion last year, estimates RCA.

But is this velocity sustainable? Multifamily sales in August, a traditionally slow month, were flat year over year. And according to Fasulo, the only way that the industry can reclaim its glory years is through an expanding list of capital options.

While life insurance companies have grown increasingly active this year, giving Fannie and Freddie a run for their money, they may not be enough for a hungry industry. Life insurance companies have a fixed amount of money to invest in commercial real estate, and given how active many of them have been this year, those allocations are starting to run out.

That fixed dynamic is a big contrast to the inherently scalable CMBS industry. “We’re approaching the level where the market cannot continue to expand without the help of CMBS,” says Fasulo. “The public markets through CMBS is really the only way that we’re going to get back to the $90 billion to $100 billion range that we saw at the height of the market.”