Real Estate Financing and Interest Rate Hedging
Background: The expansive monetary policy of the European Central Bank has been leading to all time low interest rates and to a strong move into real estate investment. Low interest rates can work in favor of the investor (due to low interest rate expenditures) but increasing interest rates can jeopardize real estate investments. Since changes in interest rates are unpredictable, an investor needs to deal with this volatility. The capital market offers several financial instruments (so called "derivatives" to overcome the above mentioned obstacle. There is no "one size fits all" strategy. The investor needs to decide which financing structure to combine with which form of derivative. Purpose: The investigation not only explains and shows how real estate financing and hedging strategies on a given project in Germany can work but also explains why it is crucial to link these segments. To achieve this purpose, the return on equity and return cash flows at risk are numerically estimated. The evaluative purpose will be served by using the abovementioned ratios and cash flows to derive recommendations of action. In doing so, this study will illustrate the importance of hedging, particularly for real estate investors and investors in general. Method: Interest rates on a monthly basis for the period of June 1990 until March 2017 from Thomson Reuters Eikon and real life data from a German real estate investor and a German financial institution were collected. Thereafter, these numbers were used as a basis to perform interest rate and cash flow simulations (Monte Carlo) The simulations were used to determine superior financing and hedging strategies for the investor. Conclusion: The results of this study highlight the benefits from leveraged financing and the necessity of interest rate risk management (hedging) to obtain stabilized future cash flows and reduce volatility caused by fluctuating interest rates. Fixed rate loans offer protection against rising interest rates, but lack flexibility. Floating loans offer more flexibility but are riskier due to the unhedged interest rate exposure.