Long-Term Treasury Yields Rise as Capital Shifts to Higher-Return

Alternatives Overseas
The Economy Today
Economic growth slowed dramatically in the first quarter, and while inflation appears to be
under control for now, it continues to fall outside the Fed’s comfort zone. There are several
opposing economic forces at work. Rising job creation and the realignment of business inventories
should lend support to economic growth figures in the second quarter, though inflationary
pressure from rising unit labor costs and high energy prices remain present. At this point, the worst
may be over for the housing market, though the impact of the unwinding subprime market remains
to be seen.

Short-term rates have remained relatively stable this year. As projected by Marcus & Millichap in
previous Outlooks and research reports, the Fed funds rate has remained unchanged year to date
as the economic drag created by the housing market has been offset by inflation concerns.

The nation’s economy has become more vulnerable to shifts in foreign capital flows and
monetary policy. Foreign holdings of long-term U.S. Treasury debt account for more than half of
the total, compared to 20 percent in the mid-1990s and 35 percent in 2000. While the influx of
foreign capital has held down interest rates over the past several years, supporting an extended real
estate boom, it has also introduced a new layer of risk.

Rapid economic expansion and rate hikes overseas, along with inflationary concerns stemming
from stronger-than-anticipated U.S. economic growth, have resulted in a 50 basis point increase
in the 10-year U.S. Treasury over the
Global GDP Comparison past six weeks. Treasury yields move
U.S. Economic Expansion Lagging inversely to prices, which have declined
in recent months as many foreign and
12% 2006 2007 Forecast domestic investors are looking abroad for
higher risk-adjusted returns.

8%
2007 Global Forecast In early June, the yield on the 10-year
U.S. Treasury reached 5.3 percent, but
rates have since edged down and appear
4%
to be stabilizing. U.S. Treasuries are still
considered to be among the safest
investments worldwide. Over the past
0%
week, the 10-year Treasury has declined
by approximately 15 basis points to 5.14
il
a

ne
a

n
o

da
UK

S.
di

az

ic

pa
in

U.
na
zo
ex
In
Ch

Br

Ja

percent as institutional investors have

ro

Ca
M

Eu

stepped up purchasing.
Sources: Marcus & Millichap Research Services, Wachovia

The information in this report is deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no
representation, warranty or guarantee, expressed or implied, may be made as to the accuracy or reliability of the information contained herein.
Sources: Marcus & Millichap Research Services, Economy.com, MBA, U.S. Treasury, U.S. Federal Reserve, Wachovia.

Erica L. Linn
National Research Manager -June 18, 2007
Marcus & Millichap Research Services Copyright 2007 Marcus & Millichap Real Estate Investment Services
(602) 952-9669 x669
 While interest rates have increased, it is important to maintain some perspective. The yield on
the 10-year U.S. Treasury has increased nearly 65 basis points since early March, but is below levels
reported in late June of last year. Looking back further, the yield on the 10-year Treasury remains
approximately 65 basis points below the long-term average.

Rates Rise but Remain Below Long-Term Average

10%
10-Year Treasury Yield

8% Average

6%

4%

2%
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06

*
07
*Through June 18
Sources: Marcus & Millichap Resarch Services, U.S. Treasury

The Outlook
U.S. GDP growth is forecast to reach 2.2 percent in 2007, given that the housing market does not
enter into another period of descent. During the first quarter, annualized GDP growth came in at
just 0.7 percent, down from 2.5 percent in the fourth quarter of 2006. First quarter GDP was
depressed by reductions in residential investment and inventory accumulation, which combined
shaved 1.9 percentage points off of the total.
It appears that manufacturers have worked through inventory issues and the worst is over for
the housing market, though there are clear risks to our outlook. To start, inflation concerns are
still present, and the housing market continues to throw off mixed signals. While many indicators
suggest the worst is behind us, residential foreclosure activity in several markets recently increased
to record high levels. Though not anticipated, a spike in interest rates could cut deeply into consumer
sentiment and send the housing market back into a downward slide.
It appears that economic growth may surprise to the upside in the near term, which could
prompt a rate hike by the Fed later in the year to stave off inflation. The yield on the 10-year U.S.
Treasury is forecast to fluctuate in the 5.0 percent to 5.5 percent range over the remainder of the
year; however, investors would be wise to build in the possibility of greater increases.

Since foreign investors and banks hold the majority of long-term U.S. Treasury debt, policy
changes abroad could have dramatic effects on U.S. interest rates. It is important to note,
however, that major holders of U.S. debt, including China and Japan, rely heavily on U.S.
businesses and consumers for their export industries. This makes it unlikely that we will see a sell-
off of U.S. Treasuries large enough to potentially derail the U.S. economy.

The information in this report is deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no
representation, warranty or guarantee, expressed or implied, may be made as to the accuracy or reliability of the information contained herein.
Sources: Marcus & Millichap Research Services, Economy.com, MBA, U.S. Treasury, U.S. Federal Reserve, Wachovia.

Erica L. Linn
National Research Manager -June 18, 2007
Marcus & Millichap Research Services Copyright 2007 Marcus & Millichap Real Estate Investment Services
(602) 952-9669 x669
 Impact of Higher Interest Rates on Real Estate
Owners should be mindful of the impact
that higher interest rates could have on cap NOI Growth Required to Maintain Value as
rates. Lenders and investors are becoming Cap Rates Rise
more discerning, and cap rates are forecast 20% +25 Bps +50 Bps +75 Bps +100 Bps
to edge up this year, particularly among
lower-quality assets or properties in less
desirable areas. 15%

Change in NOI
Rents are increasing across most property
types and markets, though in many cases, 10%
not to the degree that would support values
if cap rates were to rise by more than 25
basis points this year. For example, if the 5%
cap rate for a property increased from 6.5
percent to 6.75 percent, NOI would have to
rise by slightly less than 4 percent to 0%
maintain the property’s value; a 50 basis
6.0% 6.5% 7.0%
point increase to 7 percent would require
Starting Cap Rate
NOI growth closer to 8 percent.

Regardless of the direction of interest rates and cap rates, investors should evaluate every
opportunity to create value. Investors may be selling themselves short by overlooking the potential
value gained through better management of expenses or simple upgrades that could improve
occupancy or support stronger rent growth.

The buyer pool will contract as interest rates rise, making it increasingly important for sellers to
price properties realistically from the start. Overpricing a property can reduce a seller’s ability to
achieve maximum value. To start, sellers run the risk of missing out on the most qualified and
interested buyers. Furthermore, properties that sit on the market for an extended period of time can
be perceived negatively by potential buyers – something a price reduction cannot undo.

While capital flows into real estate remain strong, lenders are taking into account a higher
degree of risk when pricing loans. Spreads have increased approximately 25 basis points across
the board, but remain favorable when compared to just a few years ago. If economic growth does
accelerate, spreads may drift back down, though buyers are taking a significant risk by waiting on
the sidelines at this point in the cycle.

It is now crucial for investors to evaluate each property in their portfolio to determine if the
redeployment of equity could result in stronger returns, or if a property no longer fits with their
longer-term strategy. By waiting on the sidelines, owners are running the risk of missing the
opportunity to sell at peak, or at least near-peak prices and still lock financing in at comparatively
low interest rates.

The information in this report is deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no
representation, warranty or guarantee, expressed or implied, may be made as to the accuracy or reliability of the information contained herein.
Sources: Marcus & Millichap Research Services, Economy.com, MBA, U.S. Treasury, U.S. Federal Reserve, Wachovia.

Erica L. Linn
National Research Manager -June 18, 2007
Marcus & Millichap Research Services Copyright 2007 Marcus & Millichap Real Estate Investment Services
(602) 952-9669 x669