impact of loan rates on direct real estate investment holding period return, The

Financial Services Review, Summer 2004 by Larsen, James E

Focusing on our original example, we recalculate the cash flows to determine the maximum price the investor (demanding a 20.95% return) could pay for the property given a higher initial loan rate. These values are shown in column 3 of the upper panel of Table 3. At least the direction of the results, but perhaps not the magnitude of the price discounts, shown in column 3 of Table 3 will be obvious to most readers.

A less obvious effect (and the primary purpose of this study), however, is the potential impact of higher subsequent mortgage rates on the investor's holding period return. Specifically, our simulation analysis shows that failure to consider the possibility of higher subsequent loan rates means that the reversion value may be overestimated and, therefore, the investor's realized return may be less than the expected. To illustrate this point, consider a second investor contemplating purchase of Mythical Apartments at the end of the original investor's holding period. Assume that the operating cash How projections shown in Table 1 actually occurred and that the second investor has identical expectations regarding rent, expense, and property value growth rates, and plans to finance the property in a fashion identical to the original investor. These assumptions were used to generate the statement shown in Table 4. If the second investor pays $669,113 for the property (the selling price assumed by the first investor), the second investor's expected return will also be 20.95%. If, however, loan rates have increased since the original investor obtained ownership, the second investor must pay less than $669,113 to earn a return of 20.95% (i.e., the same effect of higher interest rates on purchase price that applied to the original investor shown in column 3 of Table 3 also applies to the second investor).7 To illustrate this fact the spreadsheet used to generate the statement shown in Table 4 was recalculated assuming various mortgage interest rates to determine the maximum amount that the second investor could pay (revised purchase price) and still earn the required 20.95% return. The second investor's revised purchase prices are shown in column 4 of Table 3. Finally, the spreadsheet used to generate the statement shown in Table 1 was recalculated using the second investor's revised purchase price as the original investor's gross selling price to determine the impact of the revised price on the original investor's realized return. Examination of these figures, shown in column 6 of the upper panel of Table 3, reveals that the impact on the original investor's return can be dramatic. If, for example, interest rates revert to the FHLMC historic mean (approximately 9.5%), the original investor's return could fall to 12.17%, or 8.78 percentage points lower than the desired 20.95%.8

One way an investor may be able to reduce the negative impact of increasing mortgage interest rates is to extend the holding period. Of course, extending the holding period increases the probability that the interest rate will increase from the low rates that prevail today which, ceteris paribus, would lower the reversion value. But extending the holding period also increases the cash flows from operating the property and moves the reversion value farther into the future. Both of these factors reduce the negative impact on IRR because of reduced reversion value because the present value of the reversion value will constitute a smaller percentage of the present value of the investment's total cash inflows. To demonstrate this possibility, the cash flows shown in Tables 1 and 4 were extended to 10 years (statements not shown). Again, we assume that the investor's rent and expense growth rate assumptions are realized. Next, we calculate the maximum amount that the second investor could pay and still earn the initial investor's required return assuming a variety of interest rates apply in 2013. These prices are shown in column 4 in the lower panel of Table 3. Finally, we calculate the impact of each revised selling price on the original investor's realized return. These figures are shown in column 6 in the lower panel of Table 3.