According to the Financial Forecast Center, the 30-year conventional Federal Home Loan Mortgage Corp. contract rate had an average of 6.10 percent in December, and this rate is projected to increase to approximately 6.34 percent through May. This is an increase of approximately 25 basis points, which also likely will be seen throughout the commercial lending markets. All things considered, this projected interest rate increase is fairly modest, and most economists project that the long-term interest rate should stabilize through the end of 2007. Also, compared with historical commercial lending terms, the projected 2007 interest rates still should provide favorable financing for commercial real estate purchasers throughout the coming year.

Several views exist concerning the overall impact that interest rates could have on capitalization rates. The most widely accepted notion is that values can be significantly impacted by loan terms. Thus, when lower financing costs are available, investors can achieve a targeted internal rate of return over a holding period while paying a higher price for the real estate. This correlated relationship typically will result in lower capitalization rates as buyers compete to purchase the more desirable commercial properties available.

Conversely, when interest rates are on the rise, these additional financing costs lead to lower prices, which are required to allow investors to meet specific IRR demands. This relationship typically results in higher capitalization rates.

Based on national surveys of all property types, capitalization rates remained fairly stable from 1996 through 2002, and ranged from approximately 9 percent to 10 percent. After 2002, rates began to decline and, according to the most recent data released by Price Waterhouse Cooper (Korpacz Report: 4th Quarter 2006), are currently reported at 7.28 percent for institutional-grade property and 8.88 percent for noninstitutional-grade property.

Based on 2007 economic projections, it does not appear that interest rates will increase enough to have a dramatic impact on overall capitalization rates. A moderate rise in capitalization rates may be realized, but any impact likely will be offset by improving market conditions in most of the real estate sectors.

In addition, the changes in capitalization rates have been comparable to the changes in the 10-year Treasury rate. Data compiled from December 1999 through December 2006 indicated the 10-year Treasury rate fluctuated from a low of 3.35 percent to a high of 6.03 percent. This is a fluctuation of 268 basis points. National capitalization rates for all property types fluctuated from approximately 7.28 percent to 9.75 percent over this same period. This is a fluctuation of 247 basis points. With economists projecting only a moderate increase in interest rates, there should in turn only be a moderate increase in capitalization rates into 2007.

Nonetheless, although the overall economic picture for 2007 appears to be relatively optimistic, real estate fundamentals remain somewhat weak. Many investors still are purchasing commercial real estate based on record low capitalization rates while expecting significant growth of their projected net operating income over a holding period to meet IRR expectations. These growth expectations are speculative and add a degree of risk, which is not being taken into account in the capitalization rate when making the purchase. Many of these purchases will be justified only if market conditions remain positive and net operating expectations are met.

Overall, opinions may vary as to how much of an impact rising interest rates may or may not have on capitalization rates. However, based on historical and projected data, 2007 should prove to be a year of moderate capitalization rate increases, which likely will be offset by improving economic performance in most sectors.