corporate entertainment: Commercial Real Estate's Sink-Or-Swim Moment As QE 2 Heads To Port

Commercial real estate keys on rates

The conversation, or lack thereof, surrounding the imminent termination of Ben Bernake?s QE2 among? commercial real estate professionals is a little shocking.

Last month the Fed said it wouldn?t need to extend the $600 billion buying program beyond June and there is a flurry of debate in other markets about the impact it could have on the cost of capital.? And very few on the CRE side are discussing how this would impact commercial real estate.

The intuitively appealing and logical argument is that the withdrawal of QE2 will drive up Treasury rates and thus the cost of capital.? Reducing the Federal Reserve?s Treasury buying and increasing the number of Treasury sales would seem to indicate future decreases in Treasury prices driving rates up.

No less than the noted bond king, Bill Gross of PIMCO, subscribes to this theory, so strong, in fact, that PIMCO has cut its holdings of government debt nearly to zero percent. Now that?s conviction!

However, investors are seemingly sailing toward Treasuries.? Why would they be buying more Treasuries when there are clear headwinds they will be facing after June when QE2 expires?

Perhaps they have a lack of faith in the sustainability of the rate of the economic recovery. Over the past four weeks the yield on the 10-year Treasury note fell from 3.58% to 3.16% ? the opposite of what Mr. Gross and many others would have expected.? However, the recent decline in yields is consistent with the movement of Treasury yields when QE2 began.

When QE 2 began , we saw the expected rise in economic growth and concerns regarding inflation trump QE 2 causing yields on Treasuries to actually increase.? What this means is that while many look at the ending of QE2 to divine future demand for Treasuries and Treasury rates, many other buyers are instead focusing on economic growth and inflation expectations.

Which camp will win out has far reaching implications for commercial real estate professionals, including many of today?s largest commercial real estate buyers such as SL Green Realty (SLG), Vornado Realty Trust (VNO), Boston Properties (BXP) and Blackstone Group (BX).? Buyers who focus on largely flat, long-term leases such as buyers of CVS and Walgreen will will be disproportionately impacted by the effect of QE2?s decommissioning.

Lastly, and maybe most importantly, the fate of the growing concentration of commercial real estate loans that will need to be refinanced will be directly impacted by the influence of QE2?s termination on Treasury rates.

If Treasury rates rise as a result of the end of QE2, the cost to refinance the wall of maturing commercial real estate loans will increase.? Additionally, the equity required to refinance those loans will also increase, exacerbating the equity gap for those loans.? Additionally, for investors holding properties with long-term, relatively flat leases, rising Treasury rates will diminish the value of the cash flows received eroding their real returns.

If Treasury rates fall or remain at current levels after the termination of QE2, then those needing to refinance their commercial real estate loans will benefit or remain indifferent.? While today?s buyers acquiring assets with flat, long-term leases will also benefit or be minimally impacted by the termination of QE2.

Currently it seems that expectations regarding the future rate of the economic growth is what is currently driving Treasury rates more than anything else.? And because the withdrawal of QE2 will only increase the importance of future employment growth on that rate of recovery, as commercial real estate participants the importance of focusing on jobs will only increase as we near QE2?s return to port.

Chris Macke is a senior real estate strategist for the CoStar Group and a former vice president with GE Real Estate. He has 20 years experience in commercial real estate development, acquisition, leasing and financing.