With permanent mortgage rates already up some 75 basis points year-to-date as of May, property-finance professionals were anticipating a pause in the Federal Reserve’s lengthy rate-raising efforts.

Though most experts expect the Fed to boost its overnight rate yet another quarter-point to 5.25 percent in late June, apartment borrowers are unlikely to see an increase in the spread on their loans.

The Fed may be powerful, but it’s not all-powerful.

Even if the Fed opts to increase the federal funds rate beyond its mid-May hike up to 5.0 percent, the disconnect between that rate and the benchmark 10-year Treasury yield underlying so many permanent apartment mortgages could continue. As capital markets dynamics over the past couple of years have illustrated, long-term debt costs don’t move in lock-step with the Fed’s short-term rate hikes.

Many experts seem confident that over the balance of 2006, apartment lenders won’t be able to widen the already small interest-rate spreads quoted over the 10-year Treasury or other relevant indexes. With so much capital still targeting multifamily debt, any near-term change in the spread would likely be a shrinkage, they say.

“We’re still experiencing a very, very competitive multifamily mortgage marketplace,” said Mike Kavanau, senior managing director with Holliday Fenoglio Fowler, a mortgage banking company based in Houston. So even if long-term rates rise a bit and slow borrowing activity during 2006’s second half, conduit lenders will still face heavy pressure from their optimistic investors to dole out the debt as apartment fundamentals continue to improve.

And government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac will in turn have little choice but to match Wall Street’s highly efficient pricing in order to meet their affordable housing financing mandates, Kavanau added. All of which makes any noteworthy widening of multifamily rate spreads unlikely any time soon, he said.

In fact, the spreads conduit lenders are willing to offer could compress a bit further if long-term debt rates continue upward, suggests Daniel Phelan, president and CEO of Pacific Southwest Realty Services. Lending volume tends to fall when rates rise. But investor demand for mortgage-backed bonds is so strong today, conduit lenders looking to get deals done in a lower-volume marketplace might have little choice but to compete with lower pricing, he said.

If that happens, some lenders (portfolio types especially) might just opt out of the low-spread deals and instead invest capital where they expect better risk-adjusted returns such as in commercial or office space, Phelan said. “They might not exit the business entirely, but some lenders may decline to follow the spreads downward.”

As for the relatively unpredictable life companies, some will aim to match conduit and GSE spread quotes, while others won’t play the hardball pricing game, Kavanau said. He agreed with Phelan that some portfolio lenders may cut back on bread-and-butter apartment lending if the heavy capital flow continues.

Something’s gotta give

But not everyone agrees that spreads will remain so tight. At least one financing expert cited signals that the multifamily mortgage lenders are finally gaining a bit of leverage again.

Borrowers continue reaping the benefits of an “absurdly competitive” fixed-rate multifamily finance marketplace, said John Cannon, executive vice president at GMAC Commercial Mortgage (now part of Capmark Financial Group, Inc.). Nevertheless, Cannon perceives early hints that lenders might start to regain some negotiating strength during the second half after four or five exceptionally borrower-friendly years.

Lenders aren’t quite as generous as they’ve been in recent quarters with interest-only periods, and now you can expect borrowers to pay more for the privilege through wider rate spreads. And the short-term, value-added players that still prefer floating-rate debt are also finding lenders more stingy with respect to total loan proceeds, Cannon said.

Meanwhile, Cannon believes that average spreads for bread-and-butter 10-year loans have “bottomed out” at roughly 90 to 100 basis points over the Treasury rate for “full-leverage” deals. “These are small indicators and there’s a long way to go, but I can at least say the pendulum is no longer clearly swinging toward borrowers,” he said.

Should Cannon prove to be correct, many lenders would say it’s about time, especially given the relentless upward climb of interest rates over the last two years.

Eyes on the Fed

Long-term rates are finally responding to the Fed’s increases in short-term interest rates. Shortly after the Fed’s latest overnight rate hike in mid-May, 10-year Treasuries had already risen to 5.14 percent, higher than the 5.10 percent many leading economists had predicted they would reach at the end of the year.

While that doesn’t necessarily mean the 10-year rate will be higher six months out, experts logically wonder whether further potential short-term hikes by the Fed will help push long-term rates higher. Likewise, a long pause in the federal funds rate increases wouldn’t necessarily portend a halt to the steady upward movement in long-term rates seen over the past several months.

Vice President Peter Norrie at Cohen Financial ranks among the many observers anticipating at least one more quarter-point increase in the overnight rate, when the Fed’s Open Market Committee meets in late June.

“But I don’t think a lot of us are expecting much more than that,” given the mixed news on economic growth and generally tame core inflation rate, Norrie added.

“There’s more pressure for rates to go up than down,” said Phelan. “The Fed doesn’t appear to be satisfied when it comes to inflation, and I don’t see anything in the offing to say there would be substantial movement downward.”

Kavanau also expects Fed governors to pursue a “steady” course with respect to additional rate hikes. He sees 10-year Treasuries trading at yields in the low- to mid-5 percent range over the coming 12 months, perhaps climbing as high as 5.75 percent but not as far as 6 percent.

If Kavanau’s predictions are on the money, apartment mortgage rates would likely adjust upward to the tune of maybe 30 to 50 basis points during the second half – giving them more than a 100 basis point bump over the course of the full year. At the beginning of the year, 10-year Treasury rates were at 4.4 percent, up from 3.94 percent a year earlier.

Nor do floating-rate deals stand to offer any relief under today’s pancake-flat yield curve. At about 5.08 percent, The 30-day LIBOR rate tied to most floaters was within shouting distance of 10-year Treasuries at press time. “You can just throw a blanket over all the rates,” quipped GMAC’s Cannon.

In other words, even top-tier borrowers should get used to coupon rates in the 6 percent range – while holding out hope they won’t stay there long. John B. Levy Co., a real estate investment bank based in Richmond, Va. reports that as of early April, the “prime mortgage rate range” – which it defines as the rates lenders were offering for large ($5 million or more) commercial or multifamily loans to credible borrowers – had already hit 5.97 percent to 6.07 percent. That’s a full 25-basis-point increase just since early March.

Meanwhile, if multifamily spreads tighten in coming months, there’s just not much room for lenders to budge without making lending a not-for-profit endeavor. In fact, under conceivable near-term scenarios, some experts wouldn’t be surprised if certain lenders stop competing for apartment deals.

Lenders toughen up

Lenders are already becoming less borrower-friendly when it comes to the interest-only payment structures that have played such a prominent role in debt deals over the past couple of years. Experts cite an intensifying trade-off between total dollar leverage and the length of the interest-only period, along with a renewed emphasis on operating history.

Interest-only deals are “still prevalent in the marketplace, but they’re no longer a ‘given’ as they were just a few months back,” Cannon said. “I think the smart lenders are really looking at the underlying risks, and are reluctant to offer [interest-only] structures if the borrower isn’t able to demonstrate a solid [operating and maintenance] history.”

Norrie added that lenders are shortening the interest-only periods they’re allowing with full-leverage (80-percent LTV) loans in particular. “Two years might not be a problem, but we’re seeing more resistance to five years interest-only on an 80 percent loan – especially if the property doesn’t have a proven operating history.”

Chalk it up at least in part to burgeoning resistance from the ratings agencies that assess mortgage-backed bond issues. According to a cautionary report from Moody’s Investor Service, seven of every 10 dollars conduit lenders doled out during the first quarter flowed to deals with at least some interest-only period – a level virtually triple the rate seen just two years ago.

On a brighter note for borrowers, the cost of ever-popular mezzanine capital may well continue its downward slide during the rest of 2006. Rather than tracking fixed-rate benchmarks, mezz pricing fluctuates mainly on the basis of capital supply and demand, Kavanau explained.

“We’re still seeing a lot of mezz capital being raised,” he said, adding that such a trend suggests yields are far more likely to fall than rise near-term. He said mezz yields now typically range from about 7 percent to 9 percent for deals with total leverage of up to about 83 percent; roughly 10 percent to 13 percent for deals leveraged at up to about 87 percent; and “mid- to high-teens” for properties further leveraged at up to 92 percent.