The Interest Rate Sensitivity of Real Estate

Abstract

This study yields a contribution to a better understanding of the interest rate sensitivity of real estate and should enable a more sophisticated interest rate risk management, especially for insurance companies and pension funds. This is achieved by modelling the whole life of a typical but simplified office investment property, based on a representative and exclusive data set for the Swiss investment real estate market. The interdependencies between interest rates, inflation, office market rents, current rent paid and expenses are modelled empirically. We perform Monte Carlo simulations that explicitly incorporate the uncertainty of the underlying stochastic processes, of their interdependencies and of modelling uncertainties, thus providing an indication of the final estimate’s uncertainty. Our results show that the interest rate sensitivity of a typical office property is 13.1%, with a standard deviation of 7.8%. The risk premium, the state of the macroeconomic environment, the degree of rotation of the interest curve and the remaining lifetime of the property are found to be the prime determinants of interest rate sensitivity.

Keywords: Interest Rate Sensitivity, Duration, Property, DCF, Risk Management

JEL Classification: G12, G22, G23