Among the best bets highlighted in the 2013 edition of Emerging Trends in Real Estate was the advice to lock in then-current rates rather than stay with floating-rate debt. Here we are roughly seven months later and yet another prediction is coming true, as we see that ten-year U.S. Treasury bonds are at a 22-month high and 30-year bonds are at their highest level since September 11. We, like everyone else interested in the capital markets, have spent the past week “parsing the Fed” (and watching every other credible source do likewise), attempting to decide when the Fed would reduce and/or eliminate quantitative easing (QE), and what that would do to interest rates, capitalization rates, and heart rates for that matter.

Taking the Fed at its word and assuming the unemployment rate continues to decline, reaching 6.5 percent by mid-year 2014, we are probably in the sixth or seventh inning. It’s time to make some plans for the future, trading in any and all floating-rate debt for fixed-rate debt having a term of ten years, which remains “incredibly cheap,” with top-tier paper still priced at less than 4.5 percent. But it will not be for long.

The real estate industry has a less-than-stellar reputation at playing the interest rate game; as a matter of fact, who does? It’s time to get out while the getting is good.

We know that increasing interest rates also means increasing capitalization rates, and increasing cap rates means lower property values except for those assets that have been able to increase net operating income (NOI) during a period of slowly improving property-level NOIs. If you are not sure what to do, stress-test each of your properties. Increase its interest rate on its outstanding debt, increase the capitalization rate to reflect the increase in interest rates, and value the property using its current (or near-term predicted) NOI and see what happens. Can you sustain value or not? Given the expected upward path of interest rates, can you sustain value? 

S&P: Nontraditional Lenders Raise $3 Billion

As predicted, more and more institutional real estate capital managers are forming debt funds, seeking to take advantage of the reticence of “lenders” to lend.

Highbridge Capital, owned by JP Morgan Asset management, has raised $3 billion from investors for a fund that will provide secured loans to mid-sized companies; loan size is expected to be between $30 million and $250 million. The initial focus of the fund’s lending activities is expected to be opportunities in the United States, with lending in Europe slated to begin in 2014.

This is just another example of investors looking to capitalize on the overall deleveraging in the banking sector globally.    

Monday’s Numbers

The Trepp survey for the period ending May 31, 2013, showed spreads widening slightly, with all-in costs remaining in the low–4 percent range for top-tier assets and in the mid–4 percent area for less “pristine” assets and borrowers. For the moment, lenders seem to be holding spreads steady while they watch ten-year Treasury bonds skyrocket.

Asking Spreads over U.S. Treasury Bonds in Basis Points
(Ten-Year Commercial and Multifamily Mortgage Loans
with 50% to 59% Loan-to-Value Ratios)

12/31/09

12/31/10

12/31/11

12/31/12

6/14/13

Month earlier

Office

342

214

210

210

172

178

Retail

326

207

207

192

162

166

Multifamily

318

188

202

182

150

157

Industrial

333

201

205

191

155

164

Average spread

330

203

205

194

160

166

10-Year Treasury

3.83%

3.29%

1.88%

1.64%

2.14%

1.96%

The Cushman & Wakefield Equity, Debt, and Structured Finance Group’s monthly survey of commercial real estate mortgage spreads for the one-month period ending June 3, 2013, showed spreads for ten-year, fixed-rate mortgages secured by Class A property widening as much as 40 basis points for Class A property, with spreads for Class B property widening +/-20 basis points. 

Ten-Year Fixed-Rate Commercial Real Estate Mortgages (as of May 2, 2013)

Property

Maximum
loan-to-value

Class A

Class B

Multifamily (agency)

75–80%

T +195

T +200

Multifamily (nonagency)

70–75%

T +190

T +195

Anchored retail

70–75%

T +210

T +220

Strip center

65–70%

T +230

T +240

Distribution/warehouse

65–70%

T +210

T +220

R&D/flex/industrial

65–70%

T +235

T +240

Office

65–75%

T +200

T +215

Full-service hotel

55–65%

T +265

T +290

Debt-service-coverage ratio assumed to be greater than 1.35 to 1.

 

Year-to-Date Public Equity Capital Markets

DJIA (1): +12.94%
S&P 500 (2):+11.66%
NASDAQ (3): +11.19%
Russell 2000 (4): +13.46%
Morgan Stanley U.S. REIT (5): +5.20%

(1) Dow Jones Industrial Average; (2) Standard & Poor’s 500 Stock Index; (3) NASD Composite Index; (4) Small Capitalization segment of U.S. equity universe; (5) Morgan Stanley REIT Index.

U.S. Treasury Yields

12/31/11

12/31/12

6/22/13

3-Month

0.01%

0.08%

0.05%

6-Month

0.06%

0.12%

0.09%

2-Year

0.24%

0.27%

0.38%

5-Year

0.83%

0.76%

1.42%

7-Year

1.35%

1.25%

1.95%

10-Year

1.88%

1.86%

2.52%

Key Rates (in Percentages)

Current

One year prior

Federal funds rate

0.09

0.17

Federal Reserve target rate

0.25

0.25

Prime rate

3.25

3.25

U.S. unemployment rate

7.60

8.70

1-Month LIBOR

0.19

0.25

3-Month LIBOR

0.27

0.47