After three years during which copious inexpensive credit and the prospect of rising office rents resulted in a frenzy of record-breaking transactions involving Manhattan office properties, rising rates and whispers of broken deals are causing a flutter in Manhattan real estate circles.

Analysts are saying a gradual and long-awaited widening of credit spreads is forcing borrowers to pay more for debt, occasioning speculation that the merry ride in office building prices might, at the least, take a breather.

In particular, word that the Macklowe Properties would not be taking possession of 717 Fifth Ave., one of the crown jewels of the large group of properties bought by that company from Blackstone for $7 billion earlier this year, raised concerns that Macklowe had overreached. The reality is perhaps more unsettling in these gun-slinging financial times. Apparently, the purchase was made in such haste that the organization failed to perform adequate due diligence. No one read the documents closely enough to see that a joint venture had a right of first refusal on the property should it change hands. Not surprisingly, given the recent feeding frenzy in office towers, that joint venture exercised that right.

According to one industry insider, there is indeed a tightening of credit taking place. The head of Metropolitan Real Estate Equity Management, David Sherman, puts it this way: “We’re seeing a little readjustment in the deck stack.” That means the spread between the most secure loans and those down the risk ladder is finally widening out. Some pressure has come from the ratings agencies, which have begun to tinker with the ratings criteria, causing confusion. Also, a gradual increase over the past two years in the debt component of most transactions has put lenders on alert.

Mr. Sherman says that while traditionally equity constituted some 25% of the financing behind a real estate purchase, and debt 75%, more recently buyers are raising the debt component by another 10% to 20%. This additional borrowing is generally referred to as “B-piece” or mezzanine debt. The rapid rise in the use of commercial mortgage-backed securities, which are packaged mortgages sold in the debt markets, has facilitated this escalation of borrowing by accessing a broader pool of lenders and by allowing lenders to diversify their exposure. The extra paper has found eager investors among institutions looking to put more money to work in real estate.

The recent boost in spreads is not related to a rise in delinquencies, which in the first quarter were reported by Standard and Poor’s to have hit an all-time low of less than 1%. Rather, lenders and the ratings agencies have become more concerned about the sheer volume of borrowings, and about the assumptions underlying recent transactions. Recent building purchases in Manhattan, for example, may require significant rent hikes to prove profitable. Year-to-date, CMBS issuance in America has totaled $112.6 billion, up from $72.8 billion a year ago. Spreads across the board began to rise in March. For example, charts prepared by Morgan Stanley show the spread on a fixed-rate CMBS rated BBB to have been about 120 basis points over Treasury notes in March; today the figure would be about 240bp.

One crucial source of the increase in borrowings for commercial real estate has been Blackstone’s unloading of properties purchased from Sam Zell earlier this year. Soon after completing the Equity Office Properties transaction, valued at $39 billion, Blackstone turned around and began divesting assets, including almost $25 billion in the first quarter alone. Other huge deals have also put pressure on debt markets, including Kushner Companies’ acquisition of 666 Fifth Ave. for $1.8 billion, which closed in January, and Tishman Speyer’s $5.4 billion purchase of Stuyvesant Town. In the first three months of the year, total commercial property sales in the U.S. totaled a record $119 billion.

In Manhattan, the pace and level of property sales is as dramatic as anywhere in the nation. Properties have been changing hands at ever-higher prices and at an ever-faster pace, likely causing some sloppiness among investors. (The Kushner deal, for instance, was completed soup to nuts in less than a month.) Buyers who have historically demanded returns of between 6% and 7% have been accepting returns of between 3% and 4%, so confident are they that escalating values would more than make up for the drop in current returns. The extraordinary history of the New York Times building, which changed hands for $174 million in 2004 and again at $525 million earlier this year, says it all. Other notable trades include the purchases of 350 Park Ave., 5 Times Square, and 280 Park Ave., all of which took place last year at prices of more than $1,000 a square foot. Notwithstanding the huge run-up in prices, though, some industry insiders think the market will continue strong.

Mr. Sherman cites the fast-rising price of new construction as one source of industry complacency. Shortages of building sites combined with huge increases in the cost of everything from concrete to steel, has boosted prices for new buildings. CB Richard Ellis estimates that construction costs will increase to $500 to $600 a square foot this year, up from $485 in 2006 and $349 in 2000. The cost of land is similarly rising — to an estimated $350 to $400 a square foot this year, compared with $350 to 400 in 2006 and $150 to $175 in 2000.

Also, the amount of new office construction in New York has been low in the past several years. After new additions of more than 50 million square feet in the 1960s, 1970s, and 1980s, the 1990s saw construction of less than 10 million square feet, and so far in the current decade builders have added less than 20 million square feet.

Consequently, at least at present, the economics seem to support the new level of valuations. Landlords are taking advantage of a tight leasing market to raise rents, which are needed to justify rising property values. The sale last October of 340 Madison Ave., for instance, took place at $786 a square foot. Rents on new leases in the building before the sale were $65 a square foot; after the sale, the price went to $80. Similarly, lease rates at 575 Lexington Ave., which changed hands in August of last year, jumped to $70 a square foot from $40.

A final positive in the picture is the decline in the dollar, which appears to be attracting foreign buyers. A reported offer for the boutique office condo atop Barneys at 660 Madison from Gruppo Zunino of Milan for an all-time high of $1,471 a square foot breaks new ground and could be a sign of things to come. These positive dynamics will continue to funnel money into the sector, industry observers say. Some investors who have been holding out, awaiting some rise in rates, will likely look upon the current turmoil as an opportunity to get back in. If so, the merry-go-round will not rest.

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