Like manna from heaven, historically low Treasury rates have been a veritable boon to the multifamily and commercial real estate industry and one of the key drivers of the recovery. The benefits have crossed a range of market participants. Banks and special services have taken advantage of low underlying rates when modifying loans, allowing many borrowers with negative equity to meet principal and interest obligations without their having to write down principal balances.
Very well qualified investors, borrowing at favorable spreads over exceptionally low rates, have been at the fore of renewed price discovery for core assets. In the market for trophy properties, in particular, unsecured bond issuance at implausibly low coupon rates has allowed the major listed REITs to outmaneuver other bidders.
In each of these cases, the prevailing environment of low interest rates has been a facilitator of recovery, albeit one that has not favored buyers of distress. Conversely, a shift in conditions characterized by higher interest rates bears implications for the management of distress, the cost of financing, and for commercial property values. While baseline forecasts may project another year of low long-term rates, there is every reason to consider the impact of a deviation on current lending and investment decisions. In the design of that test, it is not simply a question of what happens when interest rates move from low to high; the question asks what happens when rates move up from the lowest levels in contemporary history.
As the economic outlook improves, the mundane calculus requires that Treasury prices fall and that yields should rise. Unless spreads are narrowing in equal or greater stride, upward pressures on risk-free rates translate into higher borrowing costs and cap rates. One might argue that lending and cap rate spreads are still rather wide, but the concentration of capital in high quality assets has increasingly invalidated that line of reasoning for headline transactions. The same is true of the apartment sector, where the national fixed-rate lending spread for new originations narrowed to 180 basis points in the fourth quarter. Animal spirits are at least half-awake, leaving a thinner cushion to absorb any normalization.
Balancing Yield and Risk
Apart form the direct impact of low interest rates on borrowing costs and ceteris paribus investment returns, the absence of yield in risk-free investing has encouraged investors to migrate out along the risk spectrum. Commercial real estate markets have been among the primary beneficiaries of this adjustment. Capital inflows to the sector have been imbalanced, of course, with the most liquid segments of the market capturing the lion’s share of new investment. The recovery in prices and deal volume is incomplete but is much further along in Manhattan, Washington, D.C., and San Francisco than in other primary markets. Spillovers are observable in markets with strong support from fundamentals, such as Austin and San Jose, but remain weak where a sanguine outlook for cash flow does not offset relative illiquidity. Overall, comments made two years ago by Thomas Hoenig, then-president of the Kansas City Fed, remain instructive for our current optimism: “… Maintaining excessively low interest rates for a lengthy period runs the risk of creating new kinds of asset misallocations.”
Dark Side to an Improving Economic Outlook
In assessing the potential for a broader and more balanced investment recovery, improving investor sentiment is grease for the wheels. But evidence of modestly stronger economic and labor market outcomes has a range of consequences. Most recently, falling initial claims for unemployment insurance, a rebound in the Empire State Business Conditions index, and other metrics have supported just such a measured rise in sentiment. In turn, yields on long-dated Treasuries have adjusted in a muted variation on the standard relationship. As of last Friday, the 10-year yield had risen to 2.03 percent, up from 1.87 percent at the market’s closing bell for 2011. The magnitude of the increase is small and the absolute rate remains astonishingly low. Nevertheless, the increase corresponds with the worst starting performance for Treasuries since 2003. The asset misallocations that may pervade aspects of the market, even if only on the margin, are at risk of correcting as the adjustment progresses toward its logical conclusion.
Will Interest Rates Go Higher?
Under any normal circumstances, the Treasury yield would be higher than it is today, even if growth fell short of the economy’s potential. Its current level has little to do with the Federal Reserve Maturity Extension Program (informally, Operation Twist) and much more to do with the sovereign debt crisis in Europe. The latter has ensured strong demand for American assets, capping any rise in Treasuries. Risks of a slowdown in Mainland China may be relevant as well. If we do slide back into recession, chances are that it will follow from external factors more than domestic ones. As such, higher rates are a direct implication of a resolution to the European conundrum.
Investors and lenders who believe that risk-free rates will remain low are in the majority. There evaluation of the market bespeaks an implicit bet that Europe’s issues will remain unresolved or might even worsen before various national goals come into alignment. That is not an unreasonable view given the Continent’s political structure. Furthermore, the Fed’s new program of forecasting the target rate may have an anchoring effect upon long-term rates. Aside from discounting a durable solution to the European crisis in the near and medium terms, there is a further bet that economics and fundamentals will not lag long-term interest rate adjustments significantly once the latter do take hold. However safe we deem these gambles, there is an increasing need for them to inform the risk management equation lest they become the benefit of hindsight.
Sam Chandan, PhD, is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.