International real estate investment: 2

1. International real estate investment: 2

2. Currency: the carry trade • SWF interested in buying Turkish shopping centre • Cap rate 12% • Expected IRR 20% • Turkish bond yield/interest rate 14% • What is the leveraged return in Turkish lira? • ke = [ka-(kd*LTV)]/(1-LTV) where • ke = return on levered equity • ka = return on unlevered asset • kd = cost of debt • ke = 0.2 - (.14*.6)/(1-.6) = 0.2 - 0.084/0.4 = 29% (approx.)

3. Currency: the carry trade • SWF interested in buying Turkish shopping centre • Turkish bond yield/interest rate 14% • US bond yield/interest rate 5%; • Why not borrow US dollars to buy shopping centre? • What is the new leveraged return in Turkish lira? • ke = [ka-(kd*LTV)]/(1-LTV) • ke = 0.2 - (.05*.6)/(1-.6) = 0.17/0.4 = 42.5% (approx.) • What’s the catch?

4. Currency theories • Absolute PPP • the purchasing power of different currencies is equalized for a given basket of goods – Economist Big Mac index • Relative PPP • the difference in the rate of change in prices at home and abroad - the difference in the inflation rates - is equal to the percentage depreciation or appreciation of the exchange rate • Monetary model of exchange rates • exchange rate = f(prices, interest rates, GDP) • demand for money = supply of money and price (exchange rate) moves to keep this in balance

5. Interest rate parity • Interest rate parity is a theory which relates interest rates and exchange rates • The spot price and the forward or futures price of a currency incorporate any interest rate differentials between the two currencies • Interest rate differentials and expected currency exchange rate movements are directly related • Turkey interest rate 14%, US 5%, expected currency movement must be +9% in favour of dollar • US investor: 14% - 9% = 5% in Turkey, or direct 5% in US • Turkey investor: 5% + 9% = 14% in US, or direct 14% in Turkey

6. Fisher equation • R = l + i + RP • Difference in interest rates = difference in expected inflation • Currency appreciation = difference in interest rates = difference in expected inflation • A higher inflation currency should depreciate relative to a lower inflation currency – and will have higher interest rates

7. So what is the catch? • Turkish interest rate/bond yield 14% • US interest rate/bond yield 5% • Expected lira depreciation v dollar 9% p.a. • [2000: $0.80; 2010: $1.50 (9% depreciation p.a.)] • Impact on leveraged return?

8. Inflation, interest rates, currencies • In practice interest rates, expected inflation rates and currency exchange rate movements may not be related in the short term • For example, in ‘carry trades’ investors successfully borrow low-yielding and lend/invest in high-yielding currencies and assets • This is effective in periods of global financial and exchange rate stability • Carry trade may increase value of higher interest rate currencies – in the short run

9. What decision rule should we use? • Look for high nominal returns in local currency? • Subject to currency risk • What if market is risky? • Look for high nominal returns in domestic currency? • Requires forecast of currency exchange rate • What if market is risky? • Look for high ‘excess returns’ in domestic currency? • Requires forecast of currency exchange rate • What does risk premium cover? • Look for high ‘excess returns’ in local currency? • Adjusts for market risk • Takes out currency effect

10. Required and expected returns • Required return • IRR = RFR + Rp (risk free rate plus risk premium) • Expected return • IRR = K + G (cap rate plus appreciation) • Buy when K + G > RFR + Rp

11. High nominal returns in local currency – who are we? • We maximiseK + G • But (1): a high return market is subject to expected currency depreciation and currency risk • G is partly inflation • Inflation produces weak currency • If exchange rates stay stable we win, especially if we use low cost leverage, and we can also part-hedge by using more expensive, local debt • But (2): a high return market is subject to high property risk • IRR = RFR + Rp • If we like taking risk - we are an opportunity fund

12. Dealing with risk • We need to deal with currency and property risk • Estimate the required risk premium (RP) • Maximise the excess return: (K + G) – RFR – RP • K + G = IRR • So maximise IRR – RFR – RP

13. Dealing with risk • Example: Turkey – assume 8% RP, 14% RFR • Maximise excess return: IRR (K + G) – RFR – RP • (K + G) = 12% cap rate (K) + 8% growth (G) = 20% IRR • IRR – RFR – RP = 20% - 14% - 8% = -2%: SELL • Example: US – assume 4% RP, 5% RFR • Maximise excess return: IRR (K + G) – RFR – RP • (K + G) = 8% cap rate (K) + 2% growth (G) = 10% IRR • IRR – RFR - RP = 10% - 5% - 4% = 1%: BUY

14. Dealing with risk • Does this deal with currency? • Maximise (K + G – RFR) – RP • Inflation drives both G and RFR and cancels out • Does this deal with currency? Yes • Does this deal with property risk? • Maximise (K + G – RFR) – RP • RP is higher for risky properties • Does this deal with property risk? Yes

15. High excess returns in local currency? Who are we? • We have to estimate the required risk premium (RP) • We then maximise the excess return: IRR – RFR – RP • We are a sophisticated, risk-averse property investor • We are a core fund

16. What should we optimise? Example • High nominal returns in local currency? • Expected IRR in Turkey 20%, expected IRR in US 10% • High nominal returns in domestic currency? • Expected IRR in Turkey, US dollars, 11%, expected IRR in US 10% • High excess returns in domestic currency? • Expected IRR in Turkey, US dollars, 11% - but required return? • US: (K+G) – RFR - RP = 10% - 5% - 4% = 1%: BUY • High nominal excess returns in local currency? • US: (K+G) – RFR - RP = 10% - 5% - 4% = 1%: BUY • Turkey: (K+G) – RFR - RP = 20% - 14% - 8% = -2%: SELL

17. Should we hedge? • Invest unhedged • Random walk? • Use local debt • Loan and property value both denominated in local currency • 70% debt is a 70% capital value hedge • But introduces leverage (and Turkish rates are high) • Use a currency overlay • Focus on real estate returns • Hedge the equity • Use currency futures • Get paid for reducing risk?

18. Case: UK to Europe • Expected return on Europe 8% (6% income, 2% capital) • Expected return on UK 8% (6% income, 2% capital) • Base rate Euro 3.25% • Interest rate UK 4.25% • Margin over base rate 1% • Five year hold • UK investor • Current exchange rate €1.25: £1 • Property value £8m/€10m

19. Currency hedging Euro UK 8% return 8% return 5.25% interest 4.25% interest • Interest rate difference means inflation expectations different; lower inflation expectation means Euro is expected to appreciate • Interest rate parity means selling Euro forward for £ earns an annual payment equal to the interest rate difference, i.e. 1%

20. Case: UK to Europe • Expected value of property in 5 years: annual growth expected is 2%, so €10m * (1.02)^5 = €11.04m • What is the value of €11.04m in £? €11.04m/1.25 = £8.83m – but the exchange rate is expected to change • The Euro is expected to appreciate by 1% each year • Expected value of €11.04m in sterling? (€11.04m*(1.01)^5)/1.25 = £9.28m • So could let currency bet ride and get a capital return of £9.28/£8 = 1.16 = 1.03^5 = 3% p.a. • 3% capital return comes from 2% property, 1% currency - but this is subject to exchange rate risk

21. How do swaps work? Euro Investor Bank Sterling Investor agrees to sell € and take £ Margin? 1% on sterling – why?

22. Case: UK to Europe • Investor is long € - he has a property worth €11.04m • Sell €1.25 one year forward for £1.00 • Bank expects to pay a margin of 1%, so property investor will get £1.01 for €1.25 • For a five year swap he will get £1.01^5 = £1.051 • So he sells the property for €11.04m, swaps € for £ at €1.051, and gets €11.04m*1.051*.8 = £9.28m • Capital return is again 3% - £9.28m/£8.00m = 1.16 = 1.03^5 • This time, no currency risk

23. Hedging: using forwards • Invest £ in € fund at day 1: switch £10m for €12.5m (1.25) • Hedge currency movements by using one year forwards (commitment to sell € for £ at a fixed exchange rate) • Forward exchange rate will be determined by spot rate (1.25) plus interest rate differential (1%) = 1.26 • In one year’s time, assuming no capital appreciation, we have a building worth £10.1m, if € has appreciated by 1% • £10.1m is the new amount to be hedged – the bank has £10m, so £100,000 cash is now needed

24. Case: problems • Income? • Hedging costs • Margin and cash calls • Fees • Uncertainty over sale price • Uncertainty over sale timing

25. Should we hedge? • Simple case – investor, building • Less simple case – investor, fund, building • Complex case – investor, fund of funds, fund, building • Example: £ investor; $ denominated fund of funds; Real denominated Brazil/South America shopping centre fund; Buenos Aires asset

26. Should we hedge?

27. A return comparison (1)

28. A return comparison (2)

29. A return comparison (1)