Fed's Rate Hikes Starting to Affect CRE Loans

High interest rates are finally starting to cause commercial mortgage borrowers to pause, according to two recent commercial real estate market surveys. If so, it looks as if the Federal Reserve's move to a tighter monetary policy, which started in June 2004, is having the desired impact of reining in economic activity. The monetary authority's actions have also caused a perceptible slowdown in the economy, which initially got off to a strong start this year, and it looks as if the Federal Reserve now risks overdoing it in a bid to combat inflationary pressures.

Rising long-term interest rates, and "lofty" asset values, are finally having a dampening effect on commercial real estate investment activity, according to Prudential Real Estate Investors' midyear 2006 outlook report. Even then plenty of investment capital continues to chase real estate, although overall investment activity appears to be slowing, the real estate investment and advisory business of Prudential Financial reports. PREI expects that investment returns have hit a peak and will begin to moderate through the rest of 2006 and into 2007.

The Prudential associate expects total returns on private, unleveraged real estate investments, as measured by the National Council of Real Estate Investment Fiduciaries Property Index, to be in the 12% to 15% range in 2006.

"Real estate fundamentals have continued to improve as the economy has expanded and while transaction activity continues at a fairly brisk pace, the market appears to be slowing from its somewhat frenzied rate of recent years," notes Youguo Liang, managing director/head of PREI Research. "The balance of power seems to be shifting slightly in favor of buyers."

On the debt funding side, PREI expects markets could slow along with transaction activity, depending on how high interest rates climb. Investor demand for commercial mortgage-backed securities and collateralized debt obligations continued to drive lending activity in the first half of 2006, PREI reports, as investors continue to look for ways to bet on the property market recovery.

Higher interest rates so far appear to be affecting "transactions involving secondary markets and inferior-quality" properties.

Mr. Liang sees the multifamily market, more than any other, as being impacted by increasing long-term interest rates. He observes, "Higher mortgage rates have made home ownership even less affordable after several years of home-price appreciation. Additionally, condo conversion rates have slowed dramatically except in a few markets with high demand."

These factors, according to the report, are contributing to rising demand for rentals and double-digit rent gains in several markets, particularly in coastal areas.

In the property markets, retail is the only sector where transaction volume has declined year-over-year, off by about one-third compared with the first five months of 2005 amid concerns about consumer confidence and energy costs.

Office markets, by contrast, should see healthy rent growth, in part thanks to declining vacancy and the lack of new office development. PREI also sees a shift in investor preferences away from retail and towards the industrial and apartment sectors.

And according to a second-quarter survey by PricewaterhouseCoopers, commercial real estate investments are still going strong in spite of recent increases in interest rates, thanks to all-cash buyers that have not been impacted by the Federal Reserve's tightening.

Other concerns such as higher energy costs and the possibility of higher capitalization rates in the future have not dampened investor enthusiasm for this asset category, according to the professional services firm's Korpacz real estate investor survey.

While performance is likely to vary for individual property sectors and from market to market, the underlying fundamentals continue to inspire confidence among investors about the future, PWC reports. (c) 2006 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com