All year, the 10-year Treasury bond has defied expectations. Even as the Federal Reserve has systematically boosted the Fed funds rate from a recession-stomping 1% to 3% in just 12 months, the benchmark long-term bond — the guide for residential and commercial mortgages and other long-term loans — has fallen.

In fact, the yield on the 10-year Treasury dropped below 4% in May and again in June. Testifying before Congress in June, Fed Chairman Alan Greenspan said he couldn't explain the phenomenon and called it one of the “biggest surprises of the past year.”

No surprise, real estate markets — which accelerate or slow down depending on the cost of capital — have defied expectations, too. The low rates have created housing bubbles in major metropolitan areas as homeowners and speculators compete with one another to deploy their easy money.

And in commercial real estate, low lending rates and a flood of capital seeking relatively healthy returns have fueled an ongoing deal mania.

Smashing records

Commercial and multifamily loan originations hit a record $136 billion in 2004, up 16% from $117 billion in 2003, and are on course to set another record this year, according to the Mortgage Bankers Association (MBA). Real Capital Analytics, which tracks sales valued at $5 million or more, recorded more than $32.4 billion in office sales during the first five months of 2005, up 41% from 2004. The average office deal is now $37 million, representing a 22% increase from last year's average, according to Real Capital Analytics.

Acquisition volume in some sectors has reached alarming levels, such as the $13.3 billion spent last year to acquire apartments for conversion to condominiums, a 350% year-over-year jump, according to Real Capital Analytics.

This was not the scenario that anybody in the real estate business anticipated. Coming into 2005, the pros predicted that the 10-year Treasury yield would by now hover above 5%, and the natural course of events would ensue: the volume of transactions would slow, as would the rate of increase in property prices.

“Interest rates have definitely stayed below anticipated levels,” says Doug Duncan, chief economist at the MBA. “It has been labeled a variety of things, like a conundrum.” In December, Duncan projected a 10-year Treasury yield of 4.5% for mid-year 2005.

But interest rates are behaving in weird ways. The yield curve, which plots long- and short-term rates, usually shows a steady rise as maturities lengthen, because lenders demand a higher return to account for the higher risk (including inflation) associated with longer loans. This year, the yield curve is nearly flat. “I have not seen an accurate explanation of why the yield curve is so flat right now,” says Craig Thomas, senior vice president at Torto Wheaton Research in Boston.

Commercial real estate execs aren't the only ones who misread the signals for 2005 and are baffled by what they see at mid-year. As Greenspan told lawmakers, this situation is “clearly without recent precedent.”

Unraveling the mystery

So, what's going on? On one level, it's a question of supply and demand. There has been a huge surge in buying of U.S. government securities by foreign central banks and of U.S. assets by overseas private investors. Japanese holdings of U.S. Treasuries doubled in 2004 to $702 billion. China purchased nearly $50 billion in U.S. Treasuries last year to bring its holdings to $196 billion, even as Britain's stake tripled to $171 billion. That buying has pushed up prices and reduced 10-year bond yields, counter-acting the impact of the Fed's rate hikes.

Why all the foreign investment? The reason is that the U.S. economy is growing at two to three times the rate of Western Europe and Japan and, even at 4%, U.S. Treasuries represent a high return on a solid investment for foreign central banks. By comparison, Japanese 10-year government bonds pay less than 1%.

A looming recession in Italy and slow economic growth in Germany, France and other countries also make European investment options less appealing than U.S. bonds. “Europeans see what's happening in their countries and they want to have their money in a more prosperous place,” says Bob Von Ancken, executive managing director of advisory and valuation services at Grubb & Ellis.

For private investors in Europe, Asia and Latin America, an increasingly popular way to play the U.S. economy is through commercial real estate. Foreign purchases of U.S. commercial properties were up 50% in the first quarter and topped $2 billion for the first half of this year, according to Real Capital Analytics.

Foreign buyers were involved in nearly one quarter of the acquisitions of office buildings in the nation's central business districts in the 12 months ended March 31, reports Real Capital Analytics. The Bureau of Economic Analysis is still analyzing data from 2003, but as of 2002, U.S. affiliates of non-bank foreign companies owned more than $141 billion in U.S. commercial real estate, a number that has certainly grown since then.

Walking a tightrope

As the second half of 2005 unfolds, the nagging question is how long this scenario will play out. For now, the foreign investments are helping sustain the U.S. economy, which depends heavily on consumer spending.

The federal budget deficit could reach $350 billion in fiscal 2005. Meanwhile, the trade deficit reached a record $60.6 billion in the first quarter before narrowing to $55 billion in March. In effect, foreign investors are funding the twin deficits that underlie U.S. economic growth.

Eventually, however, something has to give. “We're at the mercy of foreign governments to continue to finance our deficit, to the tune of about $1.8 billion a day,” notes Bill Pollert, president of Capital Lease Funding, a New York-based REIT. “To the extent that they don't, it's going to adversely affect interest rates.”

In an April Washington Post op-ed piece, former Fed Chairman Paul Volcker noted that 80% of the net flow of international capital is coming to the U.S. and warned that this pattern cannot be sustained. “At some point, both central banks and private investors will have their fill of dollars.”

Volcker maps out a strategy to diffuse trade imbalances while sustaining growth, but he expresses little hope of seeing those changes enacted. His solutions include China and other Asian economies encouraging an exchange rate appreciation against the dollar (devaluing the dollar); invigorating the Japanese and European economies to promote demand for U.S. exports; and inducing a higher savings rate in the U.S. to reduce consumption of imported goods.

Warning signs

Unwinding the situation is tricky. The dollar has declined against the Euro and other currencies, but not to the level that reflects the impact of the trade deficit. That's largely because of the surge of global investment into dollar-denominated assets. That, and low interest rates, have given consumers the buying power to continue to gobble up imported goods, sustaining the economic expansion that followed the 2001 recession — and leaving the nation with a zero percent personal savings rate.

Worse, this consumer-led recovery has not produced the jobs that marked earlier expansions and drove demand for real estate. Manufacturing employment has not recovered; through last summer the nation shed 3 million jobs as demand for industrial and consumer goods were filled by overseas plants. “We're not generating the jobs that would normally come from expanding exports,” Pollert says.

Some experts contend the huge trade and federal deficits, if allowed to escalate, will trigger an abrupt drop in the dollar's value, in which case foreign investors will demand higher interest rates, or higher returns on their U.S. investments. Those rate increases will elevate prices on goods and services, reduce disposable income for consumers and slow the economy. “And that means less job growth and potentially increased unemployment,” Pollert says.

Commercial real estate threatened

In a column titled “A recipe sure to end the real estate boom” in the June issue of NREI, Anthony Downs projects a further decline in the dollar will trigger interest rate hikes, slowing the economy and possibly leading to a recession. Those higher interest rates will make the huge federal deficit more costly and pressure lawmakers to reduce the deficit, he argues.

Downs contends that it is time for the U.S. to bite the bullet and get on with the inevitable adjustment. “The sooner we do, the less severe will be this adjustment,” wrote Downs, a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California.

For real estate investors and developers, Downs has a simple message: If you have properties that you want to move out of your portfolios, do so within the next 12 months or prepare to live with them.

In other words, the anomaly of the flat yield curve and the 4% long-term interest rate is coming to an end. “It should have happened by now, and it will ultimately happen,” declares Von Ancken of Grubb & Ellis.

The new world order?

While economists such as Downs and Volcker see little chance of a painless end to the current situation, others offer a more upbeat assessment. They argue that the flow of capital to the United States will continue for several years as developing countries bring their economies up to speed. “We should be thankful the world sees us as creditworthy as they do,” says Thomas at Torto Wheaton Research.

Another reason to believe that the flows into the U.S. won't end with a sudden jolt is that the nations to which the U.S. is now in hock also depend on a healthy U.S. economy to keep paying its debt and consuming imports. “If China or any other country pulled out, they would be shooting themselves in the foot,” says Gary Schlossberg, senior economist at Wells Capital Management. Likewise, an interest-rate spike would depress U.S. demand for imports and depress the value of Fed securities. So, China and other trading partners prefer the status quo.

Against that backdrop, Dr. Rajeev Dhawan, an economist with Georgia State University, predicts continuing flows into U.S. Treasuries and an orderly rise in interest rates. He projects that the 10-year Treasury yield will rise to 5.4% in 2007. “The 10-year bond will not cross the 6% mark to cause upheaval in the mortgage market.”

Dr. Peter Linneman, a professor of real estate at Wharton School of Business in Philadelphia, is even more bullish. He says the foreign investment wave may last another 15 years. He argues that it may take that long for China, the former Soviet Union and other developing economies to establish sufficient low-risk investment options for the businesses and individuals building wealth in those countries.

Until that happens, the United States will serve as a safe haven for wealth generated overseas. “A fundamental change that many people don't understand is that the trade deficit is not about exchange rates; it's about these people wanting to invest here more than they want to consume here,” Linneman says.

Linneman also differs with the conventional wisdom that says skyrocketing prices for commercial real estate represent a bubble that will eventually burst. While longtime real estate players may consider a 5% to 6% capitalization rate unusually low, those yields are relatively good compared with alternative forms of investment, he points out.

Linneman argues that, as a gauge of risk, cap rates are still high relative to corporate bonds. He says it's more likely companies will default on their debt than default on their lease because they need a place to conduct business.

Therefore, he calculates that average cap rates on established, fully leased properties will drop to 3.5% or 4% to reflect real estate's low risk relative to other investments. “Pricing of REITs and other real estate cash streams is probably 25% to 40% too low compared to its risk,” he asserts.

Too much of a good thing

The prospect of a continuing investment frenzy in commercial real estate and declining cap rates makes some real estate observers uneasy. Real estate firms like Fort Worth, Texas-based Crescent Real Estate Equities are bracing for a continuation of the intense competition for commercial space that has characterized acquisitions for the past two years.

Cheap capital has enabled heavily leveraged buyers to remain in the acquisition game longer than expected, says Jeanette Rice, vice president of market research at Crescent, which owns and manages more than 30 million sq. ft. of office buildings in the United States. “A lot of us had hoped interest rate increases would have reduced the number of buyers by now,” she says. “Because interest rates aren't moving anywhere right now, that hasn't happened.”

Inexpensive capital and a willingness of developers and investors to accept low cap rates “is a recipe for over-construction,” says Thomas of Torto Wheaton Research. “You already have (overbuilding) in residential condominiums, and we're starting to see warehouse development beyond what tenant demand can justify in Phoenix, Las Vegas, throughout Texas and the Southeast, and just about any place it's easy to build.”

Thomas isn't alone in anticipating a construction surge. In Southern California, real estate investment company Westcore Properties is repositioning its portfolio of office and industrial properties by acquiring and redeveloping urban infill projects in prime locations.

Owen Frost, chief investment officer for the Los Angeles-based concern, believes a prolonged period of low interest rates and abundant capital will entice developers to build properties for resale to domestic and foreign investors anxious to buy commercial real estate. “There is going to be new capacity out there competing for your tenants,” Frost predicts.

Frost expects the flow of capital from China and other nations into U.S. Treasuries will keep long-term interest rates down, and that's why Westcore is girding itself against future competition. “That's an example of why a domestic real estate company has to pay attention to what's going on in China. We as an industry have to be listening to what the capital markets are saying.”

Matt Hudgins is based in Austin, Texas

ECONOMISTS' PREDICTIONS FOR YEAR-END 2005

NREI asked five economists to predict the near-term direction of key indices. Here are their responses:

Dr. Rajeev Dhawan: Director, Economic Forecasting Center, Georgia State University

Prediction: “The slowdown in China, Europe and especially Germany, plus high oil prices, will keep global growth below par.”

Douglas Duncan: Chief Economist, Mortgage Bankers Association

Prediction: “Home-loan production above $2.7 trillion, second only to the $3.9 trillion level of 2003.”

Dr. Peter Linneman: Chief Economist, Society of Office and Industrial Realtors

Prediction: “Forget about high oil prices, exchange rates, and the trade deficit; the economy is in good shape.”

Gary Schlossberg: Senior Economist, Wells Capital Management

Prediction: “Growth will rotate from consumer spending and housing to business spending that underpins manufacturing.”

Craig Thomas: Senior Vice President, Torto Wheaton Research

Prediction: “Many ill effects of higher long-term interest rates will be offset by the strong job market and household income.”

GDP (%) Growth* Job Creation (millions) 10-Year Treasury Yield (%) Oil ($ per Barrel)
Dhawan 3.3 2.2 4.7 $52
Duncan 3.5 2.2 4.4 $48
Linneman 3.8 2.2 4.6 $43
Schlossberg 3.5 1.98 4.65 $48
Thomas 3.5 2.04 5.55 $45
*GDP figures reflect total economic growth for 2005