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Interest rates riddle keeps investors on their toes.

The Federal Reserve raised interest rates from 2.75% to 3% at its May 3 meeting, the latest in a succession of consecutive 25 basis point increases that began nearly a year ago.

The rise affects directly the interest rate on floating rate loans, which move in lockstep to the Fed rate. The Fed's more optimistic statements regarding inflation at the meeting have produced the opposite effect on the fixed rate 10-year Treasury bond however, helping it sink back down after spiking in March, and could help perpetuate, at least for the time being, peak real estate values associated with low financing costs.

"Pressures on inflation have picked up in recent months and pricing power is more evident," the Fed stated, citing the rising cost of energy as one of the principal culprits.

But the Fed tempered its message by adding: "Longer-term inflation expectations remain well contained ... the Committee believes that policy accommodation can be removed at a pace that is likely to be measured."

This statement was very different from the tone of those released in March. Bond prices took a hit in March when the Fed adopted tougher language to describe the threat of inflation at its prior meeting on March 22 and touched off fears in the bond markets that it may abandon its measured pace, which has been interpreted to mean a continued series of 25 basis point increases. A sell off of 10-year Treasury bonds in the wake of the Fed's statements then triggered a yield spike of 10 basis points from 4.51% to 4.61%, not good news for the real estate industry where the cost of financing is linked directly to the 10-year Treasury rate.

With the Fed vouching that inflation now seems under control and that a "measured" pace of rate increases will be continued, the 10-year Treasury has settled down to roughly 4.25% perpetuating what Allan Greenspan has called a "conundrum," the perplexing phenomenon where the Treasury has resiliently remained low despite rising rates.

That conundrum, says Gary Gabriel, an executive director of Cushman & Wakefield in New Jersey, has been at least partly created by the ravenous appetite of foreign banks and investors, in Asia specifically, for US government bonds. But with China's recent pledges to discontinue artificially pegging is Yuan to the dollar, that massive demand could begin to decline.

"If China stops artificially tying its Yuan to the dollar, they'll be less likely to continue to invest in US dollars," Gabriel said. "And if they discontinue investing in the quantity that they do, one would think that could affect the Treasury rate." Because the period of rock bottom created such competition in the capital markets, the 10-year Treasury, which has long been considered the workhorse of real estate finance especially in times of rising short-term rates, has been increasingly replaced as of late with the 5-year Treasury bond, whose credit spreads have compressed markedly.

"The difference between the 5-year and 10-year rates has narrowed from 40 basis points a year ago to around 25 basis points," said Andrew Oliver, who is a managing director and principal at Sonnenblick Goldman and heads the firm's capital markets group. "While there is a general trend to lock into rates, it's getting more compelling to do 5-year loans especially if you want flexibility for doing things like conversions or if the buyer is going to soon sell the property."
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Author:Geiger, Daniel
Publication:Real Estate Weekly
Date:May 11, 2005
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