While predicting interest-rate movement is always a dicey proposition, 2007 appears particularly perplexing for real estate economists and other professionals trying to get a handle on the future direction of multifamily mortgage rates.
Finance pros just aren’t accustomed to entering a year with flip-flopped long- and short-term yields.
Nor are there typically so many uncertainties surrounding the economic outlook, what with certain hard-hit sectors hinting at general weakness even as Federal Reserve policymakers remain focused on inflationary pressures.
Throw in massive deficit spending by the federal government, a couple of foreign wars, and a weak dollar, and the interest rate outlook just gets cloudier.
However, capital markets experts contacted by Apartment Finance Today for the most part anticipate modest movement of long-term rates in either direction, with declines seen as more likely than increases.
Meanwhile, as the experts wonder whether heavy competition for apartment lending business can further crunch already-tight interest- rate spreads over the relevant fixed- and floating-rate indexes, the consensus is that borrowers are unlikely to see spreads widen.
Combine today’s inverted yield curve with uncertainty over the economy’s near-term direction, and the Federal Reserve’s potential reactions to both, and “all the moving pieces make for quite an unusual interest rate environment,” said Gleb Nechayev, chief economist at Torto Wheaton Research in Boston.
“There are just so many mixed signals” not only from economic indicators but from Fed officials as well, said Sam Chandan, chief economist at market data supplier Reis, Inc., in New York. Some signals, such as rising incomes and an expanding labor market, suggest economic activity remains sufficiently robust to lean toward the Fed’s inflation hawks, while others, such as slackening growth in the gross domestic product (GDP) and a weakening housing market, hint at slowing growth unlikely to generate further Fed rate hikes.
It’s no great surprise that projections of the 10-year Treasury’s year-end 2007 yield range widely among 17 leading investment banks: from 4.25 percent (Merrill Lynch) all the way up to 5.80 percent (Bear Stearns).
As for multifamily mega-lenders Fannie Mae and Freddie Mac: Their projections are just under and just over the overall investment bank average at 4.71 percent and 4.90 percent, respectively.
As Apartment Finance Today went to press in mid-December, the benchmark 10-year Treasury yield, over which most permanent fixed-rate apartment mortgages are quoted, had fallen to 4.52 percent, off from over 5 percent at mid-year. In fact, when the Fed last boosted the overnight lending rate to 5.25 percent in June, the long- versus short-term yield curve was essentially “flat.”
At that point, hardly a handful of basis points separated the 10-year Treasury from the short-term 30-day London Interbank Offered Rate (LIBOR) index, the benchmark for most short-term floating-rate commercial mortgages. Both were in the low 5 percent range at that point. But the Treasury benchmark has continued to fall, while LIBOR has hovered around the Fed Funds Rate and was in the 5.35 percent vicinity at press time.
The result: an inverted yield curve, which occurs when short-term rates become higher than long-term yields. Such inversions have historically preceded economic slowdowns. Normally, investors see long-term instruments as riskier and expect them to yield greater returns. However, when they anticipate that a sluggish economy will prompt interest rates to fall in the near future, they usually try to lock in long-term rates, even if that means they have to accept lower returns.
Even modest economic growth amounting to a 2.5 percent to 3 percent rise in GDP in 2007 would ease concerns about inflation and probably forestall any big movement in long-term rates, said Chandan. “That scenario would probably keep the 10-year Treasury relatively steady over the coming year.”
Chandan is one of many experts who expect the 10-year Treasury yield to remain relatively stable in 2007, with short-term and adjustable rates more likely to fall than rise. Andy Weiss at Meridian Capital in Bethesda, Md., is in the same camp. He foresees upward and downward pressure essentially canceling each other out during the year ahead.
Financing the federal government deficit and foreign wars will tend to put pressure on rates to rise, while concerns about a weak economy should influence Fed decisionmakers to lower rates, said Weiss. “My best guess is that rates will generally be flat; it’s hard to imagine them falling a lot.”
GDP growth is clearly the key issue for the Fed to watch near-term, said Michael Melaugh, executive managing director for capital markets at Trammell Crow Residential in Stamford, Conn. But especially given the dire impacts of a single-family housing market that’s outright “sick” today, he doubts GDP will grow even 2 percent in 2007.
If that’s the case, there’s little doubt the Fed will look to push rates down, Melaugh concluded. The 10-year Treasury may well move back to 4.25 percent during the year, “but I just don’t see anything that would move it up to 5,” he added.
In the other camp, Nechayev and colleagues at Torto Wheaton see sufficient upward pressure on long-term rates to anticipate a higher 10-year Treasury yield at the end of 2007. Federal Reserve Chairman Ben Bernanke’s comments in the fall of 2006 suggested the Fed remained focused more on inflationary pressures than threats to GDP growth, Nechayev said.
The nation’s rising international trade deficit and a weak dollar in the foreign exchange market also put upward pressure on rates, he added.
Based on Torto Wheaton’s analysis starting with the roughly 4.9 percent yield prevailing at the end of the third quarter, Nechayev is looking for about a 50 basis-point rise in the 10-year Treasury rate by the end of the year. That would push the benchmark into the mid-5s for the first time in five years.
As for short-term rates, R. Lee Harris, president of NAI Cohen-Esrey Real Estate Services, Inc., in Kansas City, predicts the Federal Funds Rate will fall perhaps 100 basis points by the end of 2007, likely moving the LIBOR into the low- to mid-4 percent vicinity. In weighing declining GDP growth and construction permits against modest inflationary pressures, “there’s a greater risk of deflation than inflation over the coming year,” Harris said.
There is little likelihood that apartment lenders will be able to widen today’s already-tight spreads over the relevant benchmarks, which ultimately determine actual mortgage “coupon” rates.
Apartment lenders charge rates computed by adding a benchmark interest rate, such as the 10-year Treasury, to a margin rate, or spread, which normally generates a profit on the loan.
“It’s hard to deny that we’re going to see all kinds of pressure on spreads in 2007,” conceded Andy Little, a real estate investment banker with John B. Levy & Co. in Richmond, Va.