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Client impact--Federal Reserve increases borrowing.

On June 30, the Federal Reserve raised the key short term borrowing rate for banks from 1% to 1.25% marking the first increase in over 4 years (Fig. A).

[FIGURE A OMITTED]

While still at historically low levels, the Fed Fund rate increase marks a new cycle of rising borrowing costs across both consumer and commercial sectors.

The Fed Fund rate has been a tool for the Federal Reserve to manage the economy--cutting rates to encourage spending in weak times, and raising rates to slow economic growth when inflation threatens. In the current environment, it seems the Fed has stuck with its strategy to "take away the punch bowl when the party has started."

As expected, the rate hike has already impacted the short term borrowing rates (especially LIBOR-based indices) for real estate investors. Longer term rates (Treasury-based indices) have already priced in the anticipated rate increases associated with a recovery. Note that since the beginning of the year LIBOR has increased 24%, while the 10 year Treasury is up only 4% (Fig B.).

[FIGURE B OMITTED]

The great disparity between short and long term rates bas created one of the steepest yield curves in history. Seductive short term LIBOR-based loans have attracted many investors with the resulting levered yield enhancement. However the yield curve has now become less steep, and the curve is expected to flatten further with short term rate increases outpacing long term rate hikes.

Greenspan in his policy statement bas indicated that the pare of any future rate hikes would continue to be "measured". And with recent mixed employment reports (June job creation off over 50% from prior 3 months), current inflationary pressures associated with economic expansion will be reduced. Rate kikes, while continued, should occur at 25 bp increments (rather than 50-75 bp bumps). Note the following consensus forecasts from 55 economists surveyed by the Wall Street Journal in July 2004 (Fig. C).

[FIGURE C OMITTED]

In addition to focus on the actual base index used to calculate real estate borrowing rates, spreads are expected to be subject to increased widening pressures. Real Estate capital markets have enjoyed an environment of historically narrow spreads over the last several years as competition from aggressive investors in the sector has created a favorable pricing environment. The thinner spreads have compensated for base rate increases and allowed all-in borrowing rates to stay relatively flat.

However, with other fixed asset classes already experiencing widening spreads, real estate spreads will come under increasing pressure to expand as investor appetite toward the sector tempers.

The cap rate compression experienced by real estate equity investors over the past 3 years bas been the direct result of: (i) Real estate as an asset class attracting capital from other sectors (bonds/equities); and (ii) Yield enhancement derived from leverage.

These related conditions have combined to create a beneficial pricing environment--driving cap rates to record lows as investors price assets aggressively. Cap rate expansion might soon be on the horizon as equity markets become more attractive in an improving economy, competitive yields for alternative vehicles increase, and borrowing costs compress leveraged real estate yields.

For real estate investors, fueling the tank with lower cost/higher volatility debt must now be a more careful decision. Value added opportunities and shorter term hold assets may still be viable candidates for LIBOR-based financing, but the risks of rate creep are a bigger gamble today. These more opportunistic investors may consider fixed rate forward options, or possible rate caps that limit exposure to further interest hikes. At the same time, investors with mid to long-term hold strategies should seriously consider fixed rate options at this time.

Under a rising rate environment, fixed rate loans should offer more predictable yields and less onerous prepayment/yield maintenance scenarios.
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Title Annotation:short term borrowing rate for banks
Author:Petz, Frank
Publication:Real Estate Weekly
Geographic Code:1USA
Date:Jul 28, 2004
Words:628
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