Reprinted from New York Real Estate Journal - October 14, 2004

Interest Rates Spike and Real Estate Values Remain Unaffected

By: Matthew Classi, Managing Member
GCP Capital Group LLC

Although still extremely low by historical measures, the recent rise in interest rates has caused the borrowing community to sit up and take notice. Sit up and notice they have, but adjust their opinion of property values, they have not. Values of recent transactions have continued to climb unabated as sales of commercial properties, especially prime income producing residential, have continued at a strong pace.
Long-term treasury rates are now approximately 125 basis points higher than their lows of early summer when the 10-year was hovering around 3%. Better multi-family buildings were locking in 10-year fixed rate mortgages in the mid 4’s. Then, seemingly overnight, there was a flight from treasuries and the 10-year spiked to 4.5% (it has since settled to today’s 4.25% levels).
Although few people thought of this rate rise in percentage terms, we actually experienced a 40% increase in the 10-year Treasury Yield; the benchmark for most long-term fixed-rate loan products. The local banking community has since increased their best 10-year fixed-rate product from just under 5% to just over 6%; a 25% increase in borrowing costs. Yet the market doesn’t skip a beat. Why?

A few reasons. First, most knowledgeable borrowers actually felt that rates were ridiculously low and some couldn’t believe the levels at which they were borrowing. No one complained, and most borrowers went to closing fighting back a smile. Loans that closed just 18-24 months prior were being paid off and often, 5% penalties were collected by the old lender. But this all made sense given the fact that rates were now 2% or more below their previous levels. By the way, this is still happening today at current rate levels, albeit at a slower pace.

Second, short term floating rates have not increased nearly as much as longer term rates have, and borrowers that ran financing assumptions using 5 or 10 year rates simply began “plugging in” LIBOR based floating rates and voila, cash-on-cash return increased. Surely any risk from rising rates will be more than offset by rising rental rates. The Lenders agree.

In my opinion, a number of other phenomenon continue to fuel real estate as well. Investors seem to have an insatiable need to complete tax-free exchanges. Large profits from the sale of other real estate assets create a need to “swap” into like kind properties or pay capital gains taxes. So there’s an entire community of buyers out there with millions to spend and the clock is ticking. These investors “reach” slightly further than other “return minded” investors, and the cycle continues.
Finally, alternative investments such as the equity markets still seem unattractive to most real estate investors. Although most have forgotten the bear real estate market of the early 90’s, none have forgotten the bear stock market of the last two years. Even though the stock market has made a respectable comeback in 2003, tangible assets that one can touch and control to some degree are still preferred to those who leave the accounting to others.

Will it ever end? Sure. We all know that. When? Your guess is as good as mine.

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