Managing Real Estate Exposure: An Empirical Analysis on Interest Rate Risk

Abstract

Real estate is an illiquid investment with cyclical returns, so risk management techniques should be used for sustainable returns. The risk management techniques include asset based, portfolio, insurance and derivatives solutions. Asset based solutions include the risk character of the real estate, based on where it’s located and how well it is developed. Some property such as foreclosure and those require maintenance is riskier than others. Portfolio solutions allow real estate companies to include real estate with different location and segments such as office and retail. Using this, the risk is limited to the systematic component, where asset based-idiosyncratic risk is tried to be reduced when included enough number of assets to the basket. The management should be capable of determining which risks taking and which to transfer. Some risks such as earthquake, fire, vehicle crush, terrorist activities are rare in nature but can cause severe damage when it takes place. The insurance policies can cover these events which most of the time are reinsured. In addition derivatives are available to hedge some of the risks. These can be traded on the market or over-the-counter. By using derivatives it is possible to hedge interest rate risk, inflation, currency risks, and property price changes. To hedge interest rate risk which is also studied in this paper, instruments such as cap, swap, and collar are available. The research is investigating the role of interest rate risk in the performance of real estate management companies. The variables used in this research are 30 years treasury yield, and exchange closing price for CBRE Group Inc., Colliers International Group, and Jones Lang LaSalle Incorporated. The data is daily for the period 16 June 2004 and 19 June 2015. The methods used are Johansen Cointegration and Granger Causality. The results of the study indicate there is a short-run and long-run relationship between interest rate and real estate management firm stock performance. In other words, interest rate fluctuation is a critical risk in performance of real estate management companies. In the paper, it is also discussed risk mitigation ideas for controlling this and other risks that real estate management industry is exposed.