Howard Levine, president and CEO of multifamily lender ARCS Commercial Mortgage, scratches his head in disbelief at the nosebleed prices buyers are willing to pay for apartments today. Cap rates as low as 4.5%? “The only justification for these low cap rates is to significantly increase rental rates, and the question everyone has to ask is whether that's in the cards,” says Levine, whose company ranked No. 21 on NREI's Top Lender Survey with $2.3 billion financed in 2003.

It's easy to understand why one of the industry's most seasoned multifamily finance executives is astounded by what's unfolding in the marketplace. The average cap rate — or initial return based on the purchase price — for garden apartments registered 7.1% nationally in the first half of 2004 compared with 7.7% during the same period in 2003, according to Real Capital Analytics.

Meanwhile, sales activity is dramatically rising, reports the New York-based research firm, which tracks deals $5 million and higher. During the first half of 2004, sales of garden properties totaled $13.7 billion, up from $10.8 billion in the first half of 2003. More dramatically, the sales volume of mid- and high-rise apartments rose from $2 billion to $4.6 billion — a whopping 129% increase.

So, what's wrong with a liquid market? The abundance of cheap debt means that some highly leveraged owners of marginally performing properties are in for a hard landing when interest rates spike up. “My concern is you're going to see an increase in the foreclosure rate in soft markets within a year,” Levine says.

But there's also a long-term problem. What happens when five or seven years from now an owner needs to refinance the existing debt on his property, the loan terms are less favorable and cap rates are rising, not falling? “A lot of borrowers haven't thought through their exit strategies,” says Levine. That's a major oversight.

But many borrowers have grown so accustomed to low interest rates that they shrug off the possibility that nothing lasts forever. The slower-than-expected economic recovery has tempered any rise in rates. The 10-year Treasury yield — the benchmark for permanent, fixed-rate financing — registered 4.22% at the close of business on Aug. 19, lower than the 4.38% recorded on Jan. 2. Floating-rate debt is still cheap. As of mid-August, the 3-month London Interbank Offering Rate (LIBOR) was listed at 1.73%.

Still, the U.S. economy is so sensitive to global events (oil prices, the war on terror and the presidential election to name a few) that gyrations in the financial markets are inevitable in the near term, says Levine. “The rubber band is so tight right now that news — good or bad — could result in more than just a blip in rates.” In other words: Borrowers beware.