Duration, Convexity and Refinancer Diversification: Credit Portfolio Management for Real Estate Professionals
Published by Michael Rose, 28.04.2021
Real estate portfolios consisting of investment properties have high implicit interest rate risks. These risks are influenced by the financing strategy chosen and can be managed in a targeted manner. Duration and convexity management always starts at the portfolio level and takes into account different interest rate scenarios as well as the steepness of the yield curve. At the portfolio level, it also makes sense to diversify the refinancing partners appropriately, with a mix of refinancers.
Real estate as a financial instrument
The value of an investment property (regardless of whether residential, commercial, hospitality or special properties) is determined mathematically by the expected future cash flow of the rental income, a possible option value due to additional utilization (opportunities to increase net income through investments and/or increased utilization) and the discount rate. In practice, the discount rate - consisting of a base interest rate and a discount rate for the the risk premium - is of considerable importance. The positive development of real estate prices in Switzerland over the last 10 years has been largely driven by the falling risk-free interest rate.
Real estate is therefore dependent on the development of the interest rate market. In Switzerland, studies for commercial real estate assume an average interest rate sensitivity of approximately 13 - a change in the discount rate of 1% thus triggers a change in value of 13%. Depending on the structure of the leases and the individual property, the expected duration may also be higher or lower. As a rule of thumb, duration is highest in the residential segment, followed by the commercial segment. The sensitivity to interest rate changes is lower in the hospitality and industrial segments, but other risks are more significant there.
A property therefore has a similar modified duration to a Swiss federal bond of around 14 years.
We assume that in the current interest rate and market environment, the duration is even higher, especially for residential properties.