As the use of debt moves up the agenda, the focus on interest rates volatility is intensifying. Edward Barker and Gerbert van Grootheest explain
This article will focus on one specific aspect of financial risk management for real estate investors: interest rate risk management.
Financial risk management - and especially interest risk management has become more and more important due to:
As the value of real estate is dependent on interest rates, either via an increase in the discount rate (proxy 10-year IRS) or increased borrowing costs for leveraged investors (proxy 3M Euribor), the volatility and height of interest rates is very relevant.
In general risk management consists of three steps:
Focusing on interest rate risk, these three steps are discussed further in this article.
Risk identification: Interest rate risk is present both on the asset side as well as the liability side of the balance sheet. Normally interest rate risk is applied to funding. The assets (ie the real estate) are to be financed with equity and debt in differing proportions. Interest will be paid on the debt portion of this capital, which makes the volatility of interest rates relevant to the established net return on the assets. The asset side - the real estate - or rather the value, is also interest rate sensitive. For example the requested investor yield depends on the actual interest rate.
Risk measurement: In the text above interest rate risks are identified (qualified). Before those risks can be managed they should be measured (quantified), because the company should know the relevance of the risk. In risk management three different measurement types can be distinguished: economic value, earnings and cash flow risk figures. Before these measures are discussed we need to consider the so-called ‘gap-analysis'.
Gap analysis: The gap is defined as the sum of all operational, investment and financial cash flows. A deficit means additional funding should be arranged, however the price (interest rate) will not be set yet. Added to this gap should be the periodic resetting of interest rates on rollover loans. This is the basic measurement of interest rate risk. Normally a maximum will be set on the gap, proportionate to the value of the portfolio, the loans or the balance sheet.
Economic value risk figures: Economic value-based measurement focus (in this case) on the possible impact of interest rate volatility on the market value(1) of on and off balance sheet products/instruments of a company. More specifically the impact of interest rate volatility on the present value of (all) future cash flows is analysed. Although these measures present the impact on the current market value, these risk figures typically give insight in the long-term interest rate risks. The reason for this is that all future cash flows are analysed. Some examples of value-based risk figures are:
Value at Risk: The best known economic value based figure is the value at risk (VaR). In general VaR is the maximum possible loss of market value within a specific period (eg one day) with a specific probability (eg 95%) resulting from changed market conditions under normal market circumstances(3)
VaR figures are commonly based on simulation models. This means that the market value is based on simulated (volatile) economic variables (in this case: interest rates). Because the interest rates fluctuate, the market value also fluctuates. After simulating the results (eg 1,000 times) a distribution of the market value occurs. The defined probability (eg 95%) results in the VaR.
Two methods of simulation are in use:
Event risk for interest rates is defined as the maximum possible loss of market value within a specific holding period (eg 10 days) with a specific probability (eg 99%) for an extreme interest rate shock. However it is also possible to specify your own events and use these to calculate the resulting event risk, instead of using historical data.
Earnings-based risk figures: In the earnings perspective, the uncertainty in the future earnings as a result of the changes in interest rates is quantified. The horizon for which this uncertainty is quantified is usually from one to several years. During this period assumptions are made on the volume of new transactions and their contribution to the earnings (a ‘living' portfolio). The resulting outcomes are usually referred to as income at stake, earnings at risk or income at risk. The earnings at risk (EaR) represents the maximum loss in accrual earnings in the first one, two or three years due to an interest rate increase (in this case). In most cases two different scenarios are analysed. The shocked scenario assumes an immediate increase of the interest rate curve; the ramped scenario assumes a gradual increase(4) within the first year. The idea behind EaR will be explained with a simple example.
Cash flow specific risk figures: The cash flow at risk (CFaR) approach gives insight in the deviation between (possible) future cash flows and the planned or budgeted cash flows within a short period (one to three years) due to changes in market factors. CFaR can be seen as the cash flow equivalent of VaR. VaR has succeeded within financial firms, while CFaR becomes more and more popular among corporates. CFaR is very useful when the risk of several uncertainties should be measured and presented in
Compared to EaR, CFaR is a more elaborate measurement tool. Amortisation of loans which are not taken into account in the EaR framework (except for the new interest rate on the refunding), are so in the CFaR framework. The refinancing of real estate portfolios is dependent on the value. If the value has declined compared to purchase, it can be difficult to refinance the loans, as banks use among other things a loan-to-value measure. This is not exactly an interest rate risk, but more a liquidity risk, although relevant this risk is slightly beyond the scope of this article.
Risk management: After the measurement of the risk positions risk management will take place, which is a continuous process. To determine whether the risk position is too high (or low) risk limits should be set. Before limits are exceeded, the risk can be decreased by conventional instruments and derivatives.
Risk limits: Risk limits should be set on several levels. A maximum should be defined on the VaR/EaR/CFaR. The risk limits should be proportional to the value and financial results of the total investment portfolio. Risk limits are set to avoid getting in solvency or liquidity problems. The internal risk limits must be compliant with externally set covenants. For instance, banks define all kinds of financial covenants, like a maximum loan-to-value, a minimum interest coverage ratio (ICR) or debt service coverage ratio (DSCR).
The risk limits will be described in a treasury or finance policy document. These documents must be approved by the board of the company. Treasury/finance will report frequently on the current positions. These reports will be verified by internal control.
These boundaries can be set at the maximum interest rate that can be paid based on the generated return. Also we can add a probability to the occurrence. Secondly we want to measure this risk. The maximum interest rate that can be paid is dependent on the loan-to-value (LTV), the higher the LTV the higher the interest cost (apart from the credit spread that normally will be higher also). We would like to manage the interest rate risk on a portfolio level instead of per loan or asset.
However, we should bear in mind that separate loan contracts contain covenants that can (or should) be applied to the separate asset or debtor. Real estate is often being held in separate entities for historic reasons or legal/fiscal issues. Based on the set boundaries, risk management is being applied. To manage interest rate risk several instruments exist. We can first choose to have a fixed or a variable interest rate on the loan(s). The variable interest rate is normally based on a Libor/Euribor-rate but alternatives are possible.
Instruments: First of all long-term loans can be attracted with the same volume and maturity equal to the volume and expected holding period of the underlying property. So if interest rates move nothing will happen with the (interest rate) result of the investment. This is the simplest way to fund your property and should be used if no interest rate risk is allowed. However, the market value of the investment at the end of the holding period has not been hedged.
If a company finds it difficult to attract long-term funding, interest rate swaps (and short-term funding) are a substitute for conventional loans to hedge the interest rate risk.
Interest rate derivatives can be transacted to manage the risk exposure. Most commonly used derivatives are caps and swaps (IRS). The instruments differ in their application, a cap is an option and protects the company against high variable interest rates during the tenor of the cap. The company can still profit from declining interest rates and knows the maximum interest rate that it should pay. The company pays a premium for the cap.
When a company would like to set a fixed interest rate for a specific tenor of the loan or investment the suitable instrument would be an interest rate swap (IRS). The company obtains certainty on the interest rate to be paid.
For an uncertain funding need a ‘swaption' (an option on a swap) can be an interesting instrument. The company can set a maximum on the interest rate to be paid, however, if no investment occurs due to diverse reasons the company can refrain from exercising the swaption, or when the swaption is in-the-money receive the market value of the swaption.
In recent years the market for interest rate derivatives has increased substantially. All kinds of variants have been introduced by a large number of banks. Almost all possible combinations can be taken into account when structuring interest rate derivatives. In assessing these derivatives it is important to break down the products into the respective building blocks. These can be priced separately to verify the pricing of the structured product. Also of importance is the understanding of the products; are they compliant with internal financing and risk management policy?
If a full simulation is not possible, at least check the outcome of the value of the product and the hedging effectiveness of the product in several scenarios. With the IFRS accounting framework, hedging relationships should be highly effective.
(1) Market value should not be interpreted as the sales price of a product, but the marked to market value.
(2) Since BPVs are additive (you can add and subtract the BPVs), the BPV of a portfolio equals the sum of BPVs per maturity bucket in that portfolio.
(3) Interest rate risk reports of financial institutions to the regulator (DNB in the Netherlands) are based on historical simulation with a one year price history, a 99% one-tailed confidence level and a one- and 10-day holding period.
(4) A gradual increase occurred in the last months in the euro interest rate market.