Last year, as executives at StarPoint Properties considered the purchase of Parkview Terrace, an apartment building in Los Angeles, many factors went into the $79-million purchase price it would eventually pay. This included the terminal cap rate—the cap rate the building would trade at if StarPoint were to sell it within the next five years. And that number was? An eyepopping—in some people's opinion—100 to 150 basis points higher than today's.

In fact, that's the firm's estimated terminal cap rate for any property it buys now, CEO and president Paul Daneshrad says.

His reasoning entails a complicated series of factors but boils down to the firm's analysis that inflationary pressure will eventually push cap rates up, despite the Federal Reserve's apparent goal of keeping them low.

"We're already seeing some inflationary effects in the economy," Daneshrad says.

And so StarPoint has staked out its position in the perennial Cap Rate Debate. The commercial real estate industry has always, of course, engaged in such analysis: Will cap rates compress any further, or will they rise over the following months and years? However, now, as we appear finally to be on the brink of growth after two years of lackluster progress, such calculations are more important than ever.

There have been a number of economic indicators pointing to a strengthening recovery. Perhaps the most encouraging—and industry specific—was the Urban Land Institute's recently released Real Estate Consensus Forecast.

The predictions were a grab bag of goodies for the industry. Vacancy rates are expected to drop in multiple asset classes by anywhere from 1.2% to 3.7%. Rents, meanwhile, are predicted to rise, by 0.8% for retail, to 5% for multifamily. CMBS issuance is expected to more than double and perhaps most significant of all, the volume of all commercial real estate transactions will increase by close to 50% over the next three years to $312 billion.

Many of these sales, if industry patterns hold true, will go on to trade hands again within five years. In short, the question of whether or not cap rates will compress or rise over the next few years is about to become relevant very quickly for an increasing number of investors. And like StarPoint, people will be placing their own bets.

And not everyone, clearly, would agree with Daneshrad's conclusions.

"Obviously cap rates and interest rates have a very strong relationship," says Kayne Anderson Real Estate Advisors Managing Partner Al Rabil. "My opinion is that, whether it is stated or not, the Federal Reserve Bank has specific near-term and medium-term interest-rate targets." Unlike Daneshrad, however, Rabil thinks the Fed will be able to maintain these targets. "I don't expect to see the 10-year Treasury rate go beyond 2.5%."

Daneshrad and Rabil hardly represent the only two opinions, though. Fine points of distinction can be made on just about any component of the cap rate argument.

"Without a doubt there's widespread puzzlement about what cap rates will do," says Peter Muoio, senior principal at Maximus Advisors, a New York Citybased research and consulting firm focused on real estate economics. "If you ask three knowledgeable people about them, you'll likely get three different and intelligent answers."

What's driving the industry nuts, he says, is that normally cap rates would be higher at this point in the cycle, and headed on a downward trajectory as the economic and real estate industry recovery continues. Instead they are at all-time lows, and it's an open question of how long that will last.

Complicating the issue is the fact that cap rates vary on a market-by-market basis, says Mike McNamara, Brookfield Properties Corp.'s head of US acquisitions and dispositions in New York City. "The most compression has happened in markets where real estate fundamentals have significantly improved," he observes. "In cities like Seattle and San Francisco, cap rates have been pushed down to ridiculously low numbers, resulting in high persquare-foot prices that, in some cases, are higher than replacement costs."

Then there are cities like New York and Washington, DC, which have seen some, but not that much, improvement in fundamentals. Cap rates compressed anyway in these cities, he says, in anticipation of greater improvement than actually occurred. "So in those markets, the cap rate compression is ahead of fundamentals," comments McNamara.

Nor does the analysis end there, especially for Washington, DC, where early projections of growth are starting to sour, casting even more uncertainty on the direction of cap rates.

Right now the formula is relatively simple, Cassidy Turley's Bill Collins says. Cap rates for core, stabilized assets in the District's Downtown and East End are between 5% and 6%. Add another 50 basis points for buildings located outside of the city's Downtown. Buildings outside the Beltway can tack on yet another 25 basis points.

The big unknown is what impact a scale back in federal spending will have on the local real estate market, Collins says. "People are trying to figure out how robust the local economy will be in a few years." That looks relatively decent, he says. It's in the near term, though, where investors are calculating possible vacancy and occupancy rates in a more conservative manner.

"A year ago, people were assuming that over 2012 and 2013, there would be rental rate growth in excess of 100 to 200 basis points above the rate of inflation," he relates. "No one thinks that today. Instead, people have penciled in zero rental-rate growth for this year and next."

The switchover from a relatively optimistic forecast—which was based largely on little new supply entering the pipeline—to this dour view happened in Q3 of 2011, Collins notes. Thats when Congress took its partisan warfare to new heights and the budget assumed a starring role in any piece of legislation.

Brokers or investors looking for guidance from a higher power—say, the lender—to help make sense of this are out of luck, says Muoio, who was a managing director and global head of Deutsche Bank Real Estate Research before he formed Maximus. "Lenders don't think in terms of cap rates, especially since they're arriving after the deal has been concluded. They focus on such metrics as debt service coverage ratios or loan to value."

Although, ultimately, he says the lender is asking the same question that the cap rate tries to answer: Is the price for this building too high?

Muoio has his own opinion as to where cap rates are headed. Treasuries will go up—possibly more than what the forward curve now suggests, he says. "We've determined that cap rates will continue to contract in the immediate term," he says. "But further down the road, say three to four years, that contraction will be balanced out by rising interest rates."

The debate about cap rates does not end there, though. Also up for grabs is when to use them—that is, when to assume a building is a stabilized core asset and when the asset must be viewed through another prism.

Shaking off the ghosts of the past five years will not be easy, no matter how robust a forecast ULI delivers. Underwriting and pro formas have gotten far more conservative and a building that was viewed as a stabilized core asset in the early 2000s could be a less-than-certain bet today, depending on the tenants and lease rollovers.

The obvious stabilized, core properties are still real estate 101, says John D. Lyons, president and CEO of Savills LLC. "When a building is already developed and is well leased with a strong list of tenants, the financial picture is fairly clear," he says. "You can get a good snapshot of how the property is performing and its probability for reaching certain financial returns from the cap rate."

For non-stabilized properties going through major renovation or transitions, such as losing an anchor tenant, lenders and investors are going to use internal rates of return or a price-per-square-foot calculation, he continues.

In an increasing number of instances, would-be buyers run the numbers using both metrics: What would be the IRR of a stabilized building located in a city where the major industry driver shows signs of weakness? Or what would be the cap rate of a property that could be leased up very quickly, despite all evidence to the contrary? (The latter happens more often than one would expect. A new buyer, especially an institutional buyer with a good reputation, lends a certain energy to a building that has been dormant. Not to mention the new capital investments it can make.)

In short, savvy investors now use more than one metric, Lyons says. "Calculating the IRR and price per square foot of a stabilized asset is not only prudent but also gives the buyer a better sense of what this asset can return over time, if there's hidden upside potential, how much additional money might be required to bring out that potential and what is the overall risk," he explains.

Lyons says he has seen investors pencil in likely IRRs for trophy assets in gateway cities just to reconfirm their decision to buy and better arrive at a price. Savills never uses one valuation tool for that reason, he adds. "When we're looking to guide our overseas clientele or purchasers or when valuing it for sellers, we want to make sure we've analyzed the asset from every different angle."

It's no secret that cap rates can be deceptive. "For example," Brookfield's McNamara says, "the majority of a building's current in-place rent might be $10 per square foot below market rate, and that'll depress a cap rate." How the cap rate is defined is also important. "Are you looking at first-year NOI over price, or are you looking at stabilized cap rates two years out?"

That's why, McNamara says, when Brookfield looks at an opportunity to buy an asset, there are a number of different measures it considers—and cap rate is just one of them. "It's still an important metric, but it's just a building's value at a moment in time."

A cap rate by itself doesn't provide much in terms of feedback, Alan Pontius, national director of special assets for Encino, CA-based Marcus & Millichap, agrees—even in the best, most stable of times. "If you look at an office with a 7.5% cap and another at a 3%, you might say the latter building was overpriced," he says. "But what if the 3% had been calculated at existing income and represented only 40% of the occupancy of the building? Now that 3% becomes an attractive going-in cap rate."

So in the overall scheme of things, a cap rate is what you make of it; that is, only one in a series of vital tools in the decision-making process. "Yes, it is a benchmark and something to react to, but by itself it has never been that good of an indicator," says Pontius. "Now, more than ever before, that's become apparent."