2005 was a record year, and 2006 looks good, too

Helped by more than $9 billion in commercial mortgage-backed securities, or CMBS, issued during the final two weeks of December, commercial mortgages were funded in record numbers in 2005.

CMBS issuance volume exceeded $169 billion during 2005 to set a record, and market observers are already indicating that the CMBS train should continue rolling in 2006.

The record volume is largely attributable to two things low interest rates and a lack of alternative investments. While a wave of investment dollars for real estate has been swelling up for five years, it exploded in 2005 with a record pace of investment sales that were fueled by compressed cap rates (the lower the capitalization rate or "cap rate," the higher the sales value).

Class A real estate in Washington that traded at a 7 percent cap rate in 2003 and early 2004 traded at a 5 percent cap in 2005. The lower cap rates were brought on by both more investment dollars going into real estate as well as low interest rates.

Aggressive purchase prices were first observed in top tier cities for Class A real estate. It quickly spread to Class B and C properties in top tier cities and then, almost as fast, it spread to secondary and tertiary markets. Here in Richmond, 2005 was a watershed year, with several downtown Class A properties trading at prices that once were only available in the best buildings in the best markets.

Perhaps as a testament to the wisdom of selling in this environment, the owner of each of the premier buildings in downtown sold off their holdings. Riverfront Plaza, the James Center and the newly constructed Riverside on the James all have different owners. Riverside on the James commanded the highest sales price on a per square foot basis at about $330 per square foot, surpassing the per square foot price on Riverfront Plaza by about $60 per square foot

Another interesting dynamic that gave real estate investors plenty to ponder in 2005 was the flattening of the yield curve. The yield curve simply describes how a line would look if you plotted the yield for various term U.S. Treasury bonds. A flat yield curve occurs when there is little difference between the yield on the 2-year and 10-year bonds. In "normal" economic circumstances, the yield curve moves gradually upward, with the yield on the shorter term Treasuries lower than the longer term Treasuries.

Today, the yield curve is very flat, and as a result, there is little difference between rates on 5-year and 10-year mortgages, which currently range from 5.50 percent to 5.60 percent, according to the Barron's/John B. Levy & Company Survey.

Interestingly, an inverted yield curve, in which short-term yields are higher than long term yields, is a good predictor of a recession. As Fidelity Investments describes on their fixed income Web site: "Inverted yield curves are rare. Never ignore them. They are always followed by economic slowdown -- or outright recession as well as lower interest rates across the board."

By the way, recessions are also bad for real estate, whether interest rates are lower or higher.

Andrew Little is an investment banker with John B. Levy & Co. He can be reached at alittle@jblevyco.com