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The Impact of Loan Rates on Direct Real Estate Investment Holding Period Return

Article excerpt

Abstract

Today's low mortgage interest rates make direct real estate investments attractive to individual investors. However, low rates may result in an investor paying too much for the property. Sensitivity analysis conducted on a set of projected financial statements for a direct real estate investment shows the potential impact of changing rates on holding period return. Higher subsequent loan rates can have a significant negative effect on the investor's return, but the impact may be mitigated by extending the holding period, individuals can use the system presented here to compare the expected return of alternate holding periods given expected interest rates. © 2004 Academy of Financial Services. All rights reserved.

JEL Classification: G12

Keywords: Holding period return; Mortgage rates; Direct real estate investment; Sensitivity analysis

1. Introduction

The literature contains numerous studies that examine the effect of including real estate investments in a mixed-asset portfolio. In general, the authors of these papers conclude that significant diversification benefits are available for investors who do so.1 Therefore, in pursuing their financial planning goals, individuals with the required capital and risk tolerance may wish to capture these benefits. While an individual can incorporate real estate into a mixed-asset portfolio with indirect investment vehicles such as real estate investment trusts, mortgage-backed securities, etc., the focus of this paper is on direct investment.

In this paper, we report the results of sensitivity analysis conducted on a set of projected financial statements, conducted to determine the impact of mortgage loan interest rates on a direct real estate investment. First, we demonstrate that initial loan rates can have a significant effect on the investor's return. Because this effect also applies to subsequent investors, we next show that higher subsequent loan rates can also dramatically affect the initial investor's holding period return. Extending the holding period may mitigate the latter effect that results from decreased reversion value. Investors can use the system presented here to help ensure that their financial planning goals are achieved because it enables them to better formulate an estimate of reversion value and to compare the expected return of alternate holding periods given a prediction of subsequent interest rates

The remainder of the paper is organized in the following manner. In the next section we review the pertinent literature. The third section contains a brief review of historical interest rates. Examples of a direct real estate investment and an analysis of the potential impact of current and subsequent interest rates on the investor's return are presented in the fourth section. A summary and conclusions appear in the last section.

2. Literature review

Financial analysis of a direct investment opportunity is an important prerequisite to investment. But what investment horizon should be used for this purpose? Ideally, one should match the analytical holding period with the actual time the investment will be in place. The literature provides no evidence concerning the degree to which this occurs, but intuition and a review of the limited available published research suggest that the match is far from perfect for institutional investors. Farragher and Kleiman (1996) analyze survey data and report that for investment analysis purposes, holding periods vary widely. Nineteen percent of the insurance company, REIT, and pension fund respondents stated that they used a holding period of five years or less; 8% reported using seven years; 70% reported using a 10-year holding period; and 3% reported the use of a 15 year holding period. The respective percentages for private investment company respondents were 33%, 13%, 47%, and 7%. Two studies of empirical data provide a measure of actual investment holding periods for institutional investors. …