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

Financial Services Review, Summer 2004 by Larsen, James E

Comparison of the original investor's revised [RR in the upper and lower panels of Table 3 shows an advantage gained by extending the holding period. Given a 10-year holding period, reversion of rates to the FHLMC historic mean (approximately 9.5%) would result in a return to the original investor only 2.24 percentage points below the target return (21.11-18.87%).

An investor can use the system presented here to compare alternative holding periods. Using the examples presented above where the investor pays $500,000 for the property, assume that expected loan rates at 2008 (for the five-year holding period) and 2013 (for the 10-year holding period) are 7% and 8%, respectively. Examination of column 6 in Table 3 indicates that the investor's expected five-year holding period return will be 17.56%, while the expected 10-year holding period return is 19.69%. These values can then be compared to the investor's required rate to determine whether the investment should be made. Alternatively, as shown in column 5 of Table 3, the model presented here can be used to estimate the growth rate in property value to be used in a spreadsheet analysis.

5. Summary and conclusions

Empirical evidence indicates that individuals may achieve diversification benefits by incorporating real estate investments into their mixed-asset portfolio. Historically, such investments have provided many investors with handsome returns. But, the low mortgage rates that prevail today introduce the possibility that individuals will pay too much for the property. The results of the sensitivity analysis conducted in this study demonstrate that the return to a direct real estate investor may be affected by changing interest rates. First, it was shown that the initial (fixed) mortgage interest rate impacts either the amount that an investor can afford to pay for the property, ceteris paribus, to earn a particular return, or (holding the purchase price constant) will impact the investor's rate of return. These results are fairly obvious, but the second issue addressed is less transparent. Next, (using holding periods that fall within the range used by institutional investors) it was shown that if the interest rate increases by the end of the investor's holding period, the reversion value may be overstated causing the realized return to be lower than anticipated. Of course, the opposite also applies; lower rates will increase both reversion value and holding period return, ceteris paribus. Given the current level of interest rates compared to historic means, however, it seems more likely that rates will he higher in the future. It was also shown that investors can reduce the impact of increased loan rates on the reversion value by extending the holding period. Doing so gives the interest rate more time to increase, but causes the reversion value to constitute a lower proportion of the investor's total return (i.e., there are more years of operating return in the IRR calculation). In addition, pushing the reversion date further into the future reduces the present value of any selling price discount.