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NEW YORK CITY-Have cap rates finally started to trend up? Real Capital Analytics reports that at midyear, cap rates hit levels not seen since year-end 2004. The national average rate rose 25 basis points to slightly more than 6.5% between April and June, but, the locally based firm notes, the uptick was largely due to a half-point increase in Treasury rates during that time.

Whether cap rates have risen depends on the particular deal in a particular market. Marcus & Millichap Real Estate Investment Services Inc.’s Linwood Thompson, Atlanta-based managing director and head of the company’s national multi housing group, says cap rates have gone up as little as 25 basis points in a class A property in a primary market, 50 to 75 basis points in a class B asset in a secondary market, and as high as 100 basis points for lower-quality properties in tertiary markets.

As a result, sales activity is up again, at least month-over-month. June’s investment volume, combined with deals slated to close in the third quarter–some $5.5 billion worth of assets–is well above recent months’ totals. However, investment volume overall is down–the $8.7 billion racked up in the second quarter was down 33% from the $13 billion posted in the first quarter. Further, the first half’s volume was down 45% from the same period a year earlier. Still, RCA notes that investors seem to feel better about apartments than other property types, since the pace of decline there was slower than in office product (-68%) and retail (-63%).

Thompson concurs that volume is down. “Our volume for the year is off almost 50%,” he says. The issue here, he points out, isn’t in operations. “On the operational side, it’s not bad out there. It’s rough in once-hot housing markets, where there may be concessions, rent declines and increasing vacancies. But on average, the markets are doing pretty well. We’re anticipating 3% rent growth on average and in many markets, occupancies are holding stable.”

Rather, says Thompson, the culprit behind the low sales velocity has more to do with the fundamentals of the investment market. “If you’re an owner and a buyer is willing to offer you 10% less than what you would have gotten a year ago, and if you don’t have to sell, you’re not going to if you don’t like that price,” he says. “That’s the expectation gap between what sellers want to believe their properties are worth and what buyers are willing to pay, and that gap has widened over the past 12 months. When that expectation gap widens, velocity drops because sellers aren’t willing to take as many deals as they were before.”

That dynamic is seen in the difference between the number of deals put on the market versus closings. There were twice as many new offerings on the market as there were closings in the second quarter. In the first six months of this year, $34.9 billion of multifamily property came to the market. The price expectation gap, combined with a difficult financing climate, has helped to nudge cap rates up. RCA analysts also note that the liquidity concerns of mortgage giants Fannie Mae and Freddie Mac–which have become the go-to lending source for apartment deals these days–could lead to a drop in their financing volume.

It isn’t that there are fewer buyers out there, says Thompson. “There are more offerings on the market than there are buyers willing to buy them at the seller’s price,” he maintains. “Whether there’s interest in the product is a function of its price. If it’s priced well, we have no problem generating offers.”

RCA found that during the first half, investors exhibited a preference for markets such as Houston and Dallas–which together, were the second and third most active cities with more than $1 billion in total deals each–versus CBD markets like Manhattan, where volume was off 60% over the first half of 2007.

No one wants to make a bad deal right now, states Thompson. In many deals, the operating partners who find and manage the deals partner up with institutional equity providers, he says. “What’s happening is those institutional sources are basically telling the operator the following: ‘Do not invest my capital in a deal where there is any chance it will be worth less 90 to 180 days from now.’ What the equity is essentially saying to the operating partner is, ‘unless you’re absolutely certain that your local market has hit bottom, don’t invest.’ That also is feeding into the lower velocity. Buyers are very nervous right now. Everyone wants to make certain we’ve hit bottom.”

And when that occurs, expect sales volume to pick up. “The real question is, which side of that gap will blink first? My guess is it will be the equity, because I don’t think sellers are going to drop their values the way people believe. As soon as people are certain we’ve hit bottom, the market will recover very quickly,” he explains. In a typical recession, the slump is on the operational side, but that’s not the case in today’s market. Whereas it would ordinarily take a year or two to turn the market around, the recovery this time through will be quicker, says Thompson. “You just have to fix expectation problems, and they’re easier to fix than operational problems,” he relates. “It might take me months to fill my vacant apartment, but I can change my mind about the market tomorrow.”

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