What is the “duration” of Swiss direct real estate?
| Date | 27 April 2010 |
| Published date | 27 April 2010 |
| Pages | 181-197 |
| DOI | https://doi.org/10.1108/14635781011048849 |
| Author | Mihnea Constantinescu |
| Subject Matter | Property management & built environment |
What is the “duration” of Swiss
direct real estate?
Mihnea Constantinescu
Swiss Finance Institute, University of Zurich, Zurich, Switzerland
Abstract
Purpose – Computing the duration of real estate assets is a challenging task due to the particularities
of the property market. This paper aims to develop an empirical model to compute the interest-rate
sensitivity of direct real estate assets in the Swiss multifamily housing market.
Design/methodology/approach – An aggregated total return index is used to empirically estimate
the interest-rate sensitivity of the underlying assets in a dynamic DCF model. No instantaneous
change is computed but a long-run price adjustment.
Findings – The long-run sensitivity is computed to be roughly 4.5 per cent. The value is found to be
statistically significant at the 1 per cent level. The model is estimated over two different time periods
and the estimate remains significant over both periods with value changing marginally. Potential
reliance of trends when forming expectations is found to be present.
Research limitations/implications – One limitation is that the computed value is valid for a
portfolio having a similar composition with the index used for the empirical estimation.
Practical implications – The value of the interest-rate sensitivity places Swiss direct real estate
assets within the European range. The value may be used to compute the risk-based capital of an
institutional investor in as far as the portfolio is similar in composition with the index.
Originality/value – The use of the dynamic DCF model allows one to split the changes in asset
prices in changes from interest-rates and changes from cashflows. No value was previously available
for the market of Swiss multifamily properties.
Keywords Interest rate, Realestate, Switzerland
Paper type Research paper
1. Introduction
Duration is a measure of the time needed for the price of a vanilla bond to be repaid by
its cash flows. It is computed as a weighted average of the times that payments are
made with weights given by the present value of the payments. Duration is measured
in years and it can be used to evaluate the exposure of the bond’s value to fluctuations
in interest-rates. Bonds with short maturities face less interest rate risk than bonds
with long maturities. The risk arises from not knowing the price at which one might
sell his bond, if needed, before maturity (default risk aside). The further into the future
the maturity, the greater the uncertainty and thus the risk carried by that bond. If an
investor acquires a bond exclusively for its cash flows and does not face any potential
need to sell the bond before maturity then the risk he faces is only that related to
reinvesting the received cash flows. Macaulay (1938) defined duration as:
The current issue and full text archive of this journal is available at
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The author wishes to thank the Swiss Insurance Association for the generous support offered in
conducting the research, the author’s PhD supervisor, professor Thorsten Hens for the
continuous guidance, and HansJoerg Germann and Andreas Loepfe for useful insights.
“Duration” of
Swiss direct real
estate
181
Received January 2010
Accepted March 2010
Journal of Property Investment &
Finance
Vol. 28 No. 3, 2010
pp. 181-197
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635781011048849
D¼X
i¼N
i¼1
PVðtiÞti
PV ð1Þ
where PV (
it
)is the present value of the payment made at time t
i
and Nis the bond’s
maturity. When the Macaulay (1938) duration is divided by (1 þyield-to-maturity)
one obtains the modified duration:
Dm
D
1þy:ð2Þ
This measure of duration is important as it represents the price sensitivity of the bond
with respect to its yield. The approximate relation is:
DP<2DmPDyð3Þ
where Pis the bond’s price and yis the bond’s yield. Once the modified duration is
computed one can more easily understand the amount of risk borne by the bond. When
the concept of modified duration is extended to a portfolio of fixed-income securities
the idea of portfolio immunization can be put into use.
As soon as the fixed-income security has random cash flows, the previous
definitions do not apply anymore because the definition of both the Macaulay (1938)
and the modified duration require predefined cash flows that are constant over time.
Bonds with embedded options have cash flows depending on the level or dynamic of
interest rates. Two measures have been developed to assess the interest-rate sensitivity
in this case, namely the empirical and the effective duration. The empirical duration is
a measure of interest-rate sensitivity computed using observed (historical) data. It is
estimated statistically by regressing usually relative changes in prices on absolute
changes in yields. This duration measure was used in estimating the interest-rate
exposure of mortgage-backed securities (DeRosa et al., 1993). Effective duration
employs simulations to evaluate the interest-rate sensitivity of fixed-income assets
with embedded options. A model for the discount rate and for the embedded option is
used; through Monte-Carlo simulations one obtains an effective duration by taking into
account the expected reaction of the cash flows with respect to a change in
interest-rates: if interest-rates decrease then cash flows might stop in the case of
puttable mortgages if the mortgage holder decides to refinance at the lower rate. This
was used for bonds with call or put options (Kalotay et al., 1993).
In all the previous cases the bond’s value and cash flows depend exclusively on the
interest rates. Evaluating the interest-rate sensitivity in these case is relatively
straightforward as one knows with a fair degree of certainty which variables to use in
the regression (in the case of empirical duration) or which option to model (in the case
of effective duration). When cash flows and values depend on other economic variables
or several inter-related options are present, the issue becomes a bit more complex.
Real estate is one such asset that does not fit in the categories defined by Kalotay
et al. (1993) and DeRosa et al. (1993): it has relatively stable cash flows (as compared to
equity) which can depend both on the state of the market and on other financial
variables (as an example the inflation-indexed contracts in the USA and Switzerland or
upward-only contracts in the UK can be considered). Real estate values will therefore
depend on interest-rates through the discount factor and through its impact on cash
JPIF
28,3
182
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