The interest rate sensitivity of real estate Alain Chaney ♣ June 24, 2009 ♣ University of Geneva...
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Transcript of 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
ERES Conference 2009July 24-27, Stockholm
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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
Motivation Data Methodology Empirical Results
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
ERES Conference 2009July 24-27, Stockholm
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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
Motivation Data Methodology Empirical Results
ERES Conference 2009July 24-27, Stockholm
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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
Motivation Data Methodology Empirical Results
ERES Conference 2009July 24-27, Stockholm
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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
Motivation Data Methodology Empirical Results
ERES Conference 2009July 24-27, Stockholm
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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
Motivation Data Methodology Empirical Results
ERES Conference 2009July 24-27, Stockholm
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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
Motivation Data Methodology Empirical Results
ERES Conference 2009July 24-27, Stockholm
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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
Motivation Data Methodology Empirical Results
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
ERES Conference 2009July 24-27, Stockholm
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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
ERES Conference 2009July 24-27, Stockholm
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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
ERES Conference 2009July 24-27, Stockholm
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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.
ERES Conference 2009July 24-27, Stockholm
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A3. Description of the Approach
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
ERES Conference 2009July 24-27, Stockholm
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A3. Description of the Approach
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
ERES Conference 2009July 24-27, Stockholm
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A3. Description of the Approach
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