WHAT FACTORS AFFECT YOUR INTEREST RATE HEDGING?

In most regions of Switzerland, there is high demand for residential space and a correspondingly low vacancy rate. At the same time, interest rates have been historically low for several years. While real estate owners agree that the current interest rate situation is extremely comfortable, there is disagreement about interest rate expectations and the urgency of interest rate hedging.

When it comes to structuring interest rate hedging, people often rely on the interest rate expectations of analysts, media representatives and their own gut feeling. The accuracy of these multi-year forecasts as well as market expectations has been low and unreliable in recent years. Especially since a possible turnaround in interest rates was repeatedly predicted but never materialized. At the beginning of 2022, a rise in interest rates, combined with a high inflation rate, is once again on everyone’s lips. Longer maturities have seen a rapid rise since Christmas. Whether the forecasts will prove to be sustainable this time remains to be seen.

With unreliable forecasts and market expectations not materializing, defining an interest rate hedging strategy is extremely difficult, as the following chart 1 also shows. Whereas a year ago the market expected negative interest rates in the short term over the next 4.5 years, today this expectation extends into 2023.

One way to counter this uncertainty is to stagger the maturities of long-term tranches. However, this solution is very rigid and active management of the real estate portfolio for acquisitions or sales is made more difficult.

In addition to interest rate expectations, there is another aspect – risk capacity, which is often neglected when hedging interest rates. This is often due to the fact that the risk is difficult to quantify. Very few owners of a real estate portfolio know concretely what a change in the interest rate situation means for the interest burden and/or for the value of the real estate portfolio.

There are relevant questions to answer in this matter:

  • How does a change in interest rates affect my interest burden and what impact does this have on the portfolio value?
  • How much do I weight planning security versus flexibility?
  • When does the rise in interest rates on longer maturities affect short-term interest rates?
  • Can I increase rental rates if financing costs rise?

 

Initial situationWith interest rate increaseChange
Money Market Mortgage0.70%2.70%+2%
Capitalization rate3.50%5.50%+2%
Market valueCHF 20’000’000CHF 12’981’818-CHF 7’018’182
Mortgage

Enfeoffment / LTV

CHF 12’000’000

60%

CHF 12’000’000

92%

 

+32%

Rental income

Interest expense

CHF 700’000

CHF 84’000

CHF 700’000

CHF 324’000

 

+386%

Table 1 – Changes in mortgage interest rates and their impact on financing costs and property values

As can be seen in Table 1, a 2% increase in interest rates has an enormous impact on refinancing costs as well as the valuation of income properties. In this fictitious example, the loan-to-value ratio increases by 32% points to 92%, which will certainly result in additional amortizations of more than CHF 300,000 p.a.. In addition, the interest expense increases by CHF 240,000. In total, this scenario burdens the cash flow with a cash outflow of more than half a million francs. This cash outflow has a direct impact on a company’s investments and possible dividend payments. In addition, the interest expense has a direct impact on the company’s profit. In this case, the interest increase accounts for about 34% of the total rental income. In order to incorporate these and other points into strategic decisions in a structured and comprehensive manner, it is advisable to define a comprehensive financing strategy. This helps the investor to base interest rate decisions on a broader basis and to take future needs into account. Corefinanz supports your clients in the development of a financing strategy and its implementation.

Do you have upcoming maturities or an undefined financing strategy? We can help you analyze your real estate portfolio and define a financing strategy.

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