Lending Advice
by Mark Levin
Editor’s Note: We are pleased to announce that Mark Levine of ARCS Commercial Mortgage will be taking over the quarterly “Lending Advice” column, covering topics related to lending, interest rates and financial news, beginning with this issue.
Q. I often hear people talk about the 10-year Treasury, especially on financial news shows, but I don’t understand why it’s so important. Should I be following movements of the 10-year Treasury, even if I only invest in stocks and real estate?
A. Before we get started, let’s first answer the question, “What is the 10-year Treasury?” Many of you know the answer and may already be bored with this column, but I think plenty of people—including myself—get a bit confused between terms such as treasuries, t-bills, notes, and fed funds. To quickly clarify, the 10-year Treasury is a note, or debt obligation, issued by the U.S. Treasury, which has a term of 10 years. In general, a note is an obligation with a term between 1 and 10 years, while a bill is a similar instrument with a term of less than 1 year and a bond has a term of more than 10 years (typically 30). The 10-year Treasury note will pay investors a guaranteed interest rate over the stated term, on a semiannual basis, and this rate will be fixed for the duration of the term.
Enough of the academics, now let’s discuss why the 10-year Treasury note is really important to both our personal and professional lives. After all, most of us are not purchasing 10-year Treasuries for our personal accounts on a regular basis, yet we track and follow the rate of this instrument fairly closely. Since the government stopped issuing 30-year Treasury bonds (the “Long Bond”) in late 2001, the 10-year Treasury note has become the lead barometer for all domestic interest-rate products. Although the government is just now starting to issue the Long Bond again (primarily in order to combat the current deficit), the 10-year Treasury note will likely remain the benchmark by which all other interest rates are measured.
In general, when we hear that the 10-year Treasury rate has risen or fallen on a certain day, we can make the safe assumption that all other government bills, notes and bonds have moved in a similar fashion. In fact, we can even make the assumption that most other fixed income products have also moved in a similar direction, since they are judged and traded according to fair value in relation to the government benchmark. Of course, there can also be unique credit and other issues that impact specific bonds, but in general they move together. These rate fluctuations have a direct impact on real estate, as well as many other aspects of the economy; most significant, perhaps, is the direct borrowing cost for many companies and countries borrowing billions and billions of U.S. dollars. Thus, even slight fluctuations in rates can have significant impacts on corporate expenses, earnings and eventually stock prices, which can affect us all very directly. Likewise, the fluctuations can significantly impact the borrowing costs of other countries, thus impacting exchange rates that resonate throughout the world.
As we narrow our focus even further, we ask why tracking the 10-year Treasury is important for Bay Area real-estate professionals. This is one of the most important questions in our industry; and it is an especially vital one for any real-estate professional, who must know the answer. Particularly in the current economic environment with a focus on rising rates, the effects on real-estate activity and prices have become increasingly important. Furthermore, with nationwide home prices in the stratosphere, the mainstream media has increased its focus on this topic, which directly affects hundreds of millions of current and potential homebuyers, in addition to multifamily and commercial investors.
The most obvious reason for real-estate professionals to take note of the 10-year Treasury relates to the direct correlation between rising rates and rising costs of real estate. Similar to impacts on corporate earnings discussed above, rising interest rates have an immediate and directly detrimental impact on the bottom line of income-producing cash flows. As borrowing becomes more costly, expenses rise without the ability to increase rents proportionally, thus negatively impacting earnings and rates of return. We can avoid these near-term fluctuations in cash flow by locking in long-term mortgage rates at today’s historically low interest rates. But so many investors have not done this and are subject to variations in the rates. To be fair, even properties financed with fixed-rate mortgages are not immune, as anticipated refinancing costs increase and thus negatively impact long-term valuations.
Another less obvious reason for the importance of tracking interest rates is the larger effect that they have on the capital markets. Domestic real estate and real-estate finance used to live in their own world, unaffected by what happened with other domestic markets and completely unfazed by international events. However, it has become increasingly evident that our industry no longer lives in this vacuum.
Much of this transformation is explained by economist and writer Thomas Friedman’s assertion that “the world is flat,” meaning (in a nutshell) that access to information and resources has been exponentially facilitated in recent years. In our business, this means that the universe of investors in real estate has expanded to numerous sources that didn’t previously have access. For instance, large real-estate investment trusts and many international investors who barely touched smaller U.S. markets are now competing for the same properties that previously were controlled by smaller, local operators. Similarly, more local investors on the West Coast are now able to efficiently seek investments in assets across the country and beyond. In an indirect manner, the effects that Treasuries have on these large companies and investors can trickle down through the ranks to eventually affect the local real-estate industry.
On a similar note, access to capital has significantly expanded in the past decade. With the evolution and enormous growth of the commercial mortgage backed securities (CMBS) market, along with the continued role that Fannie Mae and Freddie Mac play in multifamily markets, real-estate finance is now directly intertwined with larger global economies. Thus, movements in financial instruments and so many other issues that affect these economies now have indirect—and sometimes direct—impacts on local real-estate transactions. CMBS bonds, for instance, are just one type of investment on the large menu of choices for institutional investors. As Treasuries rise and fall, and other types of corporate and government bonds do the same, CMBS will be evaluated on a relative basis. At any given time, relatively huge amounts of money might flow into and out of CMBS investments, resulting in very meaningful fluctuations in mortgage rates offered to borrowers.
Real-estate professionals who consistently track the 10-year Treasury will have increased knowledge of at least one major factor affecting their business. Of course there are many other influences that move real-estate prices and transactions, but 10-year Treasury movements are increasingly influential.
Lastly, as always, it’s wise to watch Janet Yellen. For those of you who missed my last contribution to “Lending Advice,” Janet Yellen is the president of the San Francisco Federal Reserve Bank and is considered a potential frontrunner for the national Federal Reserve chair position in the post-Bush era. She was very influential under former Chairman Alan Greenspan and is likewise predicted to be under new Chair Ben Bernanke; it is vital to keep track of her influence if you have an interest in monetary policy and interest rates.
In public comments on March 16, 2006, although Yellen indicated that she expects inflation to remain “well contained,” she also stated that “inflation is now toward the upper end of [her] ‘comfort zone.’” To me, this indicates that any additional hints of inflation or continued growth in the economy would be enough to trigger further increases in the Fed Funds rate. Although the 10-year Treasury already incorporates some upward movement in the Fed’s rate, it undoubtedly would continue on its upward path under this scenario. As we now know, that would impact our national and local real-estate world from several different angles.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the San Francisco Apartment Magazine. Mark Levine is a vice president in the San Francisco office of ARCS Commercial Mortgage. He can be reached at 415-981-9700 or Mark_Levine@arcscommercial.com. Copyright © 2006 by the San Francisco Apartment Magazine. All rights reserved.