The Effect of Higher Interest Rates

In 2001, as the United States economy became mired in recession, the Federal Reserve Board lowered interest rates eleven times. The Fed continued lowering rates in 2002, finally bringing the Fed funds rate to an all-time low of 1% that year, where it remained for almost eighteen months. By June 2004, however, it was widely expected that the Fed would finally take action to raise rates and would put into effect a 25 basis point increase. In many respects this would be an almost meaningless action on the Fed’s part since rates in the U.S. Government bond market had already risen to a much greater extent. The five-year U.S. Treasury Bond, for example, reached a low in terms of yield of 2.25% in June 2003 and today, only twelve months later, it is trading 165 basis points higher, at a 3.90% yield basis. With the U.S. economy continuing to grow at a very rapid rate and with huge Government deficits needing to be financed, there can be no doubt that interest rates will be under upward pressure for the foreseeable future.

The increase in interest rates will have varying affects on the real estate market in the United States. Falcon’s principal conclusions as to the effects of higher interest rates are:

1. 1. Even though the Federal Reserve Board is expected to raise the Fed funds rate at least two more times in 2004, we do not expect mortgage rates to change significantly from where they are today for the balance of the year.
2. 2. Demand for real estate should remain strong for the rest of the year holding capitalization rates around present levels in the short term.
3. 3. The fundamentals in the real estate market – occupancy levels and rental rates – should continue to improve for the remainder of 2004 and into 2005.

Our analysis of these three questions is outlined below.

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The Mortgage Market:

The Government bond market experienced an extraordinarily rapid rise in interest rates after the Federal Reserve Board merely hinted that it was becoming more amenable to some increase in the Fed Funds rate. Both the bond and the stock markets generally move quickly to anticipate coming events, but it seems clear that, in this case, the bond market may have over-reacted to the prospect of higher rates. An increase of over 150 basis points during the past twelve months in the rates for most bond maturities is not really compatible with the Fed’s much more gradual approach to tightening. Therefore, unless there is some dramatic change in the economic situation, rates on the five and ten-year U.S. Government bonds should remain in a fairly narrow range for the rest of the year, even though the Fed may make additional increases in the Fed funds rate as the year progresses. Since the market had clearly anticipated that the Fed would raise rates in June as well as on a number of occasions in the future, it seems quite likely that there may be a period of relative stability in the bond market, at least for the balance of 2004. As a result, real estate mortgage interest rates, which are generally set as a spread over interest rates in the Government bond market, should also remain in a range that is close to their present level – 5.75% to 6.25% on a five-year mortgage and 6.50% to 7.00% on a ten-year mortgage.

Another factor that will have an effect on mortgage interest rates is the spread that mortgage lenders will require over rates in the bond market. There is apparently a great deal of mortgage money available today and the mortgage market has become fairly competitive. As a result, spreads that had reached levels of 250 to 275 basis points have tended to narrow as interest rates have risen, so that we are currently receiving quotes in a range of 200 to 250 basis points over comparable maturity U.S. Government bonds. This narrowing of spreads has mitigated to some extent the rise in underlying interest rates in the bond market.

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