Real estate researchers say the spread between the 10-year Treasury yield and interest rates on fixed-rate mortgages will remain at 115 to 120 basis points and won't return to the first quarter's 90 to 100 basis point spread, now that lenders are re-pricing risk. Yet buyers could regain some of their recently lost buying power later this year, if interest rates or asset prices begin to fall as some predict.

Most economists expect the 10-year Treasury yield to stay perched above 5% and gradually trend upward next year, barring a recession. The highly leveraged buyer is more likely to make his way back into the game through a reduction in asset prices.

In light of the re-pricing of risk, some asset prices are peaking, researchers say. Capitalization rates, or initial yields on acquisitions based on the purchase price, are leveling off and have even widened 25 to 50 basis points in cities off the radar screens of equity-rich investors, according to Hessam Nadji, managing director of research services at Marcus & Millichap. That's not the case in major cities dominated by institutional investors, which use less leverage than most private investors.

Commercial real estate prices have soared over the past three years and caused cap rates to compress. The average cap rate for multi-tenant office properties plummeted from 8.5% in the first quarter of 2004 to 5.75% in the first quarter this year, according to Real Capital Analytics, which tracks deals $5 million and higher.

Deal volume has flattened for properties valued below $10 million, which are less likely to draw interest from institutional investors. In smaller markets dominated by private investors, Nadji expects cap rates to rise this year, bringing prices within the shortened reach of leveraged buyers.

That presents a problem for passive investors, who are less likely to see asset values appreciate without leasing, management, or property improvements.

Whether loan volumes will drop in response to the surge in capital costs remains to be seen. The most recent data available from the Mortgage Bankers Association shows commercial real estate lending volume in the first quarter up 37% from a year ago. Volume was down 15% from the fourth quarter, attributable to an end-of-year rush to close deals.

Investors who grew accustomed to highly leveraged deals have two options: come up with more equity or seek additional leverage outside conduit lending. That leverage is available for borrowers willing to pay for it.

Mezzanine loans, which are secured by an interest in a property's owner, are plentiful and helping to fill the void left by shrinking senior loan proceeds, says Carroll, the regional manager at KeyBank Real Estate Capital.

“There's still plenty of capital out there for a good project,” Carroll says. “It's just that the capital is more expensive than it was.” Interest rates on mezzanine loans now range from 8% to 15%, unchanged from a year ago, according to KeyBank.

Lenders that provide mezzanine and other bridge loans are enjoying the increased demand for floating-rate debt, says Ryan Krauch, principal of Los Angeles-based Mesa West Capital LLC. The influx, he says, marks a return to more traditional borrowing patterns, in which floating-rate debt is used for value-add or transitional properties and fixed-rate loans serve stabilized properties.

“The question is whether this hiccup in the fixed-rate side is short term or long term. Most people are preparing for it to be a long-term adjustment,” says Krauch.

Investors feeling overwhelmed by capital costs should shop around before selecting a loan because some lenders are overreacting to risk aversion in the CMBS markets and charging higher rates than their competitors, says Pelusi of Holliday Fenoglio Fowler.

“Three to six months ago, if you took a property out and exposed it to the market, all of the [loan] bids might have been within five basis points of each other. Today that spread could be as wide as 25 basis points between better quotes and run-of-the-mill quotes,” Pelusi says. “It really pays to expose your property to the market and do your due diligence as a borrower.”

Borrowers shouldn't despair over rising capital costs. Mortgage rates below 7% are still attractive. The challenge in the second half of 2007 and beyond is to adapt investment strategies and prepare to come up with a little more equity, or a little more cash flow, to make deals work.

“It's not the end of the real estate market,” says Tenzer of George Smith Partners. “Investors are borrowing in the sixes [percent]. Historically, that's an incredibly low rate, and that has to be kept in mind. And there's still a tremendous amount of liquidity.”

Matt Hudgins is an Austin-based writer.

NREI asked eight forecasters to predict the direction of key indices. Here are their responses:

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

Prediction: “The Fed will cut interest rates by a total of 75 basis points this summer.”

Dana Johnson: Chief Economist, Comerica Bank

Prediction: “We're in what will turn out to be the longest post-war expansion we've ever seen.”

Hessam Nadji: Managing Director of Research Services, Marcus & Millichap

Prediction: “The positives are going to outweigh the negatives, and we'll avoid recession.”

Josh Scoville: Director, Strategic Research, Property & Portfolio Research Inc.

Prediction: “Some of the underwriting assumptions being made today, especially in terms of future rent growth, will fail to materialize.”

James Smith: Chief Economist, Parsec Financial Management

Prediction: “The economy will come out of a six-month recession in the fourth quarter of 2007 and make up all its lost ground.”

Diane Swonk: Chief Economist, Mesirow Financial

Prediction: “Prepare for irrational exuberance from foreign investment.”

Craig Thomas: Senior Vice President, Torto Wheaton Research

Prediction: “The economy begins 2008 stronger than it began 2007.”

Jamie Woodwell: Senior Director, Commercial Research, Mortgage

Bankers Association Prediction: “No Fed movement, upward or downward, in 2007.”

	GDP (%) growth	Core CPI inflation rate (%)	Monthly job growth	10-year Treasury yield (%)	Crude oil ($ per barrel)
Dhawan	1.9	2.2	72,000	4.75	$58
Johnson	2.25	2.2	130,000	5.25	$60
Nadji	2.3	2.2	75,000	4.75	$60
Scoville	2.5	2.3	100,000	5.1	$55
Smith	0.5	1.1	196,000	4.14	$31.75
Swonk	3.0	2.0	140,000	5.1	$63
Thomas	3.0	2.9	129,200	5.17	$60
Woodwell	2.2	2.3	120,000	5.0	$69