the interest rate sensitivity of real estate alain chaney ♣ june 24, 2009 ♣ university of geneva...

The interest rate sensitivity of real estate

Alain Chaney♣

June 24, 2009

♣ University of Geneva (HEC), Switzerland (PhD Student),

Informations- und Ausbildungszentrum für Immobilien, Switzerland, (Consultant)

and Neue Aargauer Bank, Switzerland (Risk Manager)

ERES Conference 2009July 24-27, Stockholm

2

1. Motivation

2. Data

3. Methodology

4. Empirical Results

Outline

Motivation Data Methodology Empirical Results


3

Previous work

Survey ApproachEstimated duration

Ward (1988)DCF-formula;simulation of formula parameters

2.8 to 36

Hartzell et al. (1988) 0 to 6

Adams et al. (1999) 11.4 to >100

Brown (2000)Equivalent Yield Model (DCF);use of IPD statistics for formula parameters (i.e. rental values, income received and equivalent yields)

12.8

Hamelink et al. (2002)

Use of Ward's formula;empirical estimates of formula parameters (i.e. discount rate, growth rate and inflation flow-through)

3.2


Despite the facts that… real estate plays an important role for many financial investors interest rate risk is difficult to diversify traditional estimates of the interest rate sensitivity (i.e. Macaulay and

Modified Duration) are not applicable to real estate…surprisingly little research performed on impact of interest rate changes on the value of a property


4

Previous work and research questions

Past studies Are based on simplistic DCF formulae Duration derived by simulating values for formulae parameters

(Ward [1988], Hartzell et al. [1988], Adams [1999]) and / or empirical estimation up to a maximum of 3 formula parameters(Brown [2000], Hamelink et al. [2002])

Indication of accuracy of final estimates is missing

Research questions How sensitive is the value of office properties to changes in

interest rates…

…and how accurate is this measure?

T

tt

t

t

r

FCF

1 1



5

Data

Variable Source

Inflation Federal Statistic Office

LIBOR 3 month Reuters

Euromarket 3 month Swiss National Bank

Term structure (money market rates and yields of Confederation bonds)

Swiss National Bank

Office market rent Swiss National Bank

GDP State Secretariat for Economic Affairs

Vacancy rate IAZI Swiss Property Benchmark

Expenses IAZI Swiss Property Benchmark

CPI indexation degree IAZI AG

Term of leases IAZI AG

Risk premium Hedonic discount rate model from IAZI AG

Public statistics

Exclusive data from the Swiss property database owned by IAZI



6

Basic idea

The interest rate sensitivity is equal to

Investment properties are usually valued according to the DCF method

➢ Required time series of FCF and of discount rates pay special attention on how discount rates and FCF change

following a change in interest rates

rV

VVD

rr

effective

2

T

ttd

t

t

r

FCFV

1 1



7

Approach

1. Model important macroeconomic time series and their interdependencies interest rates, inflation, economic condition, office market rent

2. Simulate the whole life of a typical office property, that is embedded in the macroeconomic environment, in order to derive the FCF FCF = CRP - EX, where CRP = f(MR, VAC, TOL, I, DII)

3. Use of MCS to incorporate the uncertainty of underlying stochastic processes of the time series and their interdependencies, i.e. of the modelling uncertainties



8

Results

➢ Modelled macro economy is plausible…

Key figure Sim. Historical (avg; [80% CI]) R2 Sample

rf 3m real 1.1%1.0% [-0.3% ; 1.8%]1.2% [-0.3% ; 3.5%]

Inf: 57.2%rf: 91.2%

1994-20091974-2009

GDP real 1.6%1.4% [-0.7% ; 3.6%]1.9% [-0.5% ; 4.2%]

70.4%1975-20081966-2008

RENT real 1.5% 1.2% [-2.0% ; 5.6%] 62.7% 1972-2008

➢ …and applied valuation approach is accurate, i.e. represents the historical stochastic property behaviour as well as the market valuations of office properties

Key figure Sim. Historical (avg; [80% CI]) Source

NCF return 4.42% 4.40% [2.41% ; 6.40%] IAZI SPB® 2000-2008

Vacancy 3.91% 3.91% [0.00% ; 18.66%] IAZI SPB® 2000-2008 0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

freq

uen

cy

1 6 11 16 21 26 31 36

Term of Leases

Market

Simulation

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%-1

.75

-1.2

5

-0.7

5

-0.2

5

0.25

0.75

1.25

1.75

2.25

2.75

3.25

3.75

4.25

Fre

qu

en

cy

historical inf lation 01/94-03/09price stability acc. to SNBsimulated inf lation



9

Results

Main determinants of interest rate sensitivity

State of the macroeconomic environment (level of interest rates, inflation, GDP growth, steepness of term structure)

Property’s risk premium and remaining lifetime

Office properties provide a fairly good hedge against changes in the short term interest rates


0%

1%

2%

3%

4%

5%

6%

7%

-15%

-5%

5%

15%

25%

35%

45%

Fre

qu

en

cy

Duration Distribution

90% Confidence Interval

The interest rate sensitivity of a typical office property, embedded in an average macroeconomic environment is equal to 13.1% and associated with a standard deviation of 6%

Appendix


11

A1. Traditional Duration Estimates

Macaulay-Duration (present value weighted time

until the receipt of the CF)

Modified Duration (% change in value)

Lead to a Duration of real estate of roughly 20 years, or 20 %

Are based on 3 basic assumptions

1. Flat term structure

2. Parallel shift of the term structure only, i.e. no rotation

3. Cash flows do not change when interest rates change

n

t

tt

Mac

yCFt

D1 price bond

)1(

rDD MacMod

1

1

Source:

ww

w.pascalroussel.net


12

A2. Swiss Term Structures since 01/1999

0

1

2

3

4

5

6

0 5 10 15 20 25 30 35 40

grosse Streuungkleine Streuung

Time to maturity

Le

vel o

f ris

k fr

ee

inte

rest

ra

tes

high stdevlow stdev


13

A3. Description of the Approach

Inflation

possible simulation results from AR(2) model (with structural break in mean inflation rate in 19941)

-2

0

2

4

6

8

10

12

14

Inflation

Preisstabilität gem. SNBprice stability (SNB)

inflation

1) Because time dummy was most significant for this year (p-value = 0.0593) within a pre-specified range of possible break dates ranging from 1993 up to 2000. According to time series plot, during 1993 and 2000 Swiss inflation as well as its volatility declined. Additionally, Switzerland joined the Breton Woods institutions in 1993, while at the beginning of 2000 Switzerland abandoned the monetary targeting in favour of a new policy framework based on explicit definition of price stability as the SNB’s overriding long term goal.


14


Short term interest rates

result from one simulation run

-2

0

2

4

6

8

10

12

14

Jan

73

Jan

78

Jan

83

Jan

88

Jan

93

Jan

98

Jan

03

Jan

08

Inf lation

LIBOR 3m

Euromarket 3m

Historical comparision


15


Interest curve

time to maturity

Leve

l of

inte

rest

rat

es %

-

0.5

1.0

1.5

2.0

2.5

3.0

3.5

0 5 10 15 20 25 30 35 40 45 50

Zinskurve 03/2009 gemäss Modell

Zinskurve nach Zinsschock von+0.5%

Zinskurve 03/2009

0.7-0.2=0.5

3.1-2.8=0.3

Interest curve acc. to model

Interest curve after interest rate shock by +0.5%

Interest curve march 2009


16


Simulated

time series

4.3

4.8

5.3

5.8

6.3

6.8

0 20 40 60 80 100time

ln()

tentant change vacancy CRP

market rent FCF EC

-2%

0%

2%

4%

6%

0 20 40 60 80 100

inflation LIBOR3m Preisstabilität SNB

-

1

2

3

4

0 20 40 60 80 100time

average term structure

term structure after LIBOR3m -1%

-2%

0%

2%

4%

6%

0 20 40 60 80 100

inflation LIBOR3m price stability SNB

4.3

4.8

5.3

5.8

6.3

6.8

0 20 40 60 80 100

tenant change vacancy CRP

market rent FCF EC

the interest rate sensitivity of real estate alain chaney ♣ june 24, 2009 ♣ university of geneva...

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