1. 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)

2. ERES Conference 2009 July 24-27, Stockholm 2 1.Motivation 2.Data 3.Methodology 4.Empirical Results Outline MotivationDataMethodologyEmpirical Results

3. ERES Conference 2009 July 24-27, Stockholm 3 Previous work SurveyApproach Estimated 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 MotivationDataMethodologyEmpirical 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

4. ERES Conference 2009 July 24-27, Stockholm 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? MotivationDataMethodologyEmpirical Results

5. ERES Conference 2009 July 24-27, Stockholm 5 Data VariableSource InflationFederal Statistic Office LIBOR 3 monthReuters Euromarket 3 monthSwiss National Bank Term structure (money market rates and yields of Confederation bonds) Swiss National Bank Office market rentSwiss National Bank GDPState Secretariat for Economic Affairs Vacancy rateIAZI Swiss Property Benchmark ExpensesIAZI Swiss Property Benchmark CPI indexation degreeIAZI AG Term of leasesIAZI AG Risk premiumHedonic discount rate model from IAZI AG Public statistics Exclusive data from the Swiss property database owned by IAZI MotivationDataMethodologyEmpirical Results

6. ERES Conference 2009 July 24-27, Stockholm 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 MotivationDataMethodologyEmpirical Results

7. ERES Conference 2009 July 24-27, Stockholm 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 MotivationDataMethodologyEmpirical Results

8. ERES Conference 2009 July 24-27, Stockholm 8 Results ➢ Modelled macro economy is plausible… Key figureSim.Historical (avg; [80% CI])R2R2 Sample r f 3m real1.1% 1.0% [-0.3% ; 1.8%] 1.2% [-0.3% ; 3.5%] Inf: 57.2% r f : 91.2% 1994-2009 1974-2009 GDP real1.6% 1.4% [-0.7% ; 3.6%] 1.9% [-0.5% ; 4.2%] 70.4% 1975-2008 1966-2008 RENT real1.5%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 figureSim.Historical (avg; [80% CI])Source NCF return4.42%4.40% [2.41% ; 6.40%]IAZI SPB ® 2000-2008 Vacancy3.91%3.91% [0.00% ; 18.66%]IAZI SPB ® 2000-2008 MotivationDataMethodologyEmpirical Results

9. ERES Conference 2009 July 24-27, Stockholm 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 MotivationDataMethodologyEmpirical Results  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%

10. Appendix

11. ERES Conference 2009 July 24-27, Stockholm 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 Source: www.pascalroussel.net

12. ERES Conference 2009 July 24-27, Stockholm 12 A2. Swiss Term Structures since 01/1999 Time to maturity Level of risk free interest rates high stdev low stdev

13. ERES Conference 2009 July 24-27, Stockholm 13 A3. Description of the Approach  Inflation possible simulation results from AR(2) model (with structural break in mean inflation rate in 1994 1 ) price 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. ERES Conference 2009 July 24-27, Stockholm 14 A3. Description of the Approach  Short term interest rates result from one simulation run Historical comparision

15. ERES Conference 2009 July 24-27, Stockholm 15 A3. Description of the Approach  Interest curve time to maturity Level of interest rates % 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. ERES Conference 2009 July 24-27, Stockholm 16 A3. Description of the Approach  Simulated time series