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CRE Finance World, Autumn 2013

The initial adjustment on the order of about 100 basis points, in absolute terms may not be terribly large, but in relative terms it certainly has been. We saw that rates bottomed out on the 10-year around 1.4 to 1.5%. Since then, the risk-free yield underlying borrowing costs has nearly doubled as rates have come up closer to 3%. The outlook for the economy did not change materially during that period; it’s naïve to assume that every increase in Treasuries will be offset by a commensurate adjustment in the economic forecast. Looking forward to what the rest of the year might hold, there are a couple of things going on. It’s not that the underlying economy or capital market conditions are sufficiently strong that we will see rates trend toward their long-term averages at this point. Whether it is the Federal Reserve or other institutional market participants, there are still some forces working to keep long-term rates low. We have the potential for a more significant upward adjustment but it won’t necessarily come from any specific moves that would be made by the Fed, or any specific commentary that would come from the chairman of the Federal Reserve. When we look back at research that has been done, their own estimate of how directly impactful something like quantitative easing has been or can be on Treasury rates, the direct impact is fairly modest. What the Fed has a significant role in doing is shaping the expectations of other participants in the market with regard to where it will set its inflation targets, and how aggressive it will be in supporting its current monetary policy bias. And then it’s the flow of capital from all sorts of other sources that ends up being what determines where we sit with the yield curve. There is an acknowledgement within the Fed that adjustment in their language has generated observable responses in the financial markets. At this point, I think they are being cautious in their choice of words even more so than they usually are. Although they might be in agreement that rates have to trend higher in the long run, exaggerated volatility in the rate market makes it difficult to invest, lend, and anticipate what investment flows will look like. That will make their assessment of the economy harder to read. Expectations are that some of the downside risks to economic growth have abated. Although they may not have a more sanguine view of what growth will be in 2013, they see fewer downside risks. That’s even after accounting for fiscal drags and dysfunction in Congress. They’re not seeing as many of the stress scenarios being as severe. That certainly helps. But they’re not expecting runaway growth. The wildcard in some of this is the pending nomination of the next chairperson of the Federal Reserve. At this point in September and certainly following the announcement by Larry Summers that he would not pursue the nomination, the odds weigh heavily toward CRE Finance World Autumn 2013 10 Janet Yellen. The markets are taking that potential very well. Janet Yellen is perceived as being in close alignment with Chairman Bernanke, in terms of her views of appropriate monetary policy and how accommodative the Federal Reserve should be. Compared to some other candidates where we might anticipate a more abrupt tightening of policy over the course of the next 6 to 12 months, with the appointment of Janet Yellen to that role, we would really see the Federal Reserve stay the current course if she can rally the other voting members. Lisa Pendergast: All financial markets knew the Fed would begin to ‘taper’ and eventually cease altogether its $85 billion in monthly Treasury and mortgage purchases. In fact, many believe it has gone on too long already. The question I have is that even when the Fed begins to taper, Chairman Bernanke has said that the Fed Funds rate would remain at or close to zero for some time to come. Shouldn’t that be enough to prevent a sharp gap higher in rates? Sam Chandan: On the short end of the yield-curve, the Fed exercises a far greater degree of control. Based on the information they have available to themselves at this point, their expectation is that they will keep those targets at or near zero for the next couple of years. If the economy were to suddenly start growing quickly, if job growth were to pick up, if inflationary pressures came to bear in a more significant way, they’re not ruling out the possibility that they would adjust those short-term targets. The more immediate concern for investors in our industry is the long-term rate, where the Fed is influential but not omnipotent. What do higher rates mean for property valuation and for financing costs? In the data that we’re collecting, with regard to borrowing costs, there is preliminary evidence that during the third quarter, for properties of comparable risk, duration, and loan structure, rates have increased. Did they go up by 100 basis points? No, they didn’t. Some of the increase has been absorbed into the spreads. But the relationship is not fixed. That’s where it becomes a real issue. When you look around the various commercial real estate markets, for example in some of the markets where fundamentals have lagged, where investors are more concerned about illiquidity, where the capacity to absorb rate increases into spreads is more limited, whether it be the cap rate or the borrowing cost, managing investors’ demands for higher yields is more challenging. It’s there that we see a greater degree of responsiveness in borrowing costs and cap rates. It doesn’t play out in the same way in every market. Lisa Pendergast: Thank you Sam. I’m going to turn now to the lenders on the call. To me, the recovery in commercial real estate has been uneven, but it has been there. The significant difference between commercial and multifamily real estate markets and the single-family residential market is that we’ve CRE Finance World Roundtable: Macro Issues Facing CRE Finance “As long as there aren’t those sticker shock moments, where you wake up one day and rates are way different from yesterday and you’re getting significantly less proceeds or more expensive proceeds — commerce will take place.”


CRE Finance World, Autumn 2013
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