5.5 / 18 - International Real Estate Investments

Question 1

LO 18.1: Demonstrate knowledge of the basic concepts of international real estate investing.

Answer 1

• Discuss the primary obstacles, benefits, and risks of investing in real estate internationally.

Question 2

Roundtrip costs

Answer 2

the total costs and fees of buying and selling securities, which can be quite substantial for international real estate.

Question 3

Risks of International Real Estate Investment

Answer 3

• Forex Risk: can produce the greatest source of vol for int’l RE (since income tends to be stable) - Higher vol - econmic, political, legal, and tax risks

Question 4

Int’l RE invested and investable universe size

Answer 4

$33 trillion for Europe, NA, and Asia Pac 2012 estimate

Question 5

LO 18.2: Demonstrate knowledge of the opportunities associated with international real estate investing.

Answer 5

• Explain why investment in international real estate is generally associated with higher expected returns. • Analyze the potential diversification benefits associated with allocations to international real estate from both theoretical and empirical perspectives. • Evaluate the effect of income taxation on the performance of, and optimal allocations to, real estate investments from a global perspective. • Analyze and calculate the effect of depreciation tax shields on international real estate investments. • Explain and calculate the effect of deferral of taxation of gains on international real estate investments. • Discuss the combined effects of depreciation, deferral, and leverage on international real estate investments. • Explain and calculate the effect of leverage on international real estate investments.

Question 6

How Does INt’l RE returns compare to Domestic RE, and why?

Answer 6

Int’l RE can generate higher returns, due to macro and country specific variables. e.g. Emerging market econs due to faster population growth and urbanization growth trends

Question 7

Does int’l RE offer diversification benefits?

Answer 7

• signficant benefits, yes, due to low correlation between traditional investments and int’l RE - Currency risk can reduce diversification benefit. Can be difficult to hedge due to cost and availability in some regions (reduce returns).

Question 8

Depreciation Tax Shield

Answer 8

Depreciation is a noncash, before-tax expense (reduces tax). The tax savings can have a substantial impact on after-tax Cash flows.

Question 9

Formula for Present VAlue of the depreciation tax shield

Answer 9

present value of the tax savings form the depreciation of an asset:

Question 10

Deffering Income Taxes

Answer 10

Achieved by dudcting depreciation for tax purposes - kicking the can down the road, since there is likely to be a gain when property is sold.

Question 11

After-tax rate with & and without tax deferral (equations)

Answer 11

After-Tax rate without tax deferral:

after-tax rate without tax deferral = r × (1 – tax rate)

after-tax rate with tax deferral

= [1 + [(1 + r)^T – 1] × (1 – tax rate)]^1/T – 1

where: T = number of years taxes are deferred

Question 12

Equation for leveraged return on equity:

Answer 12

R_lev = R_assets × L

where:
R_lev = leveraged return on equity
R_assets = return on assets
L= leverage factor (i.e., assets/equity).

Question 13

Equation for Volatility of a leveraged transaction

Answer 13

σ_lev = L × σ_assets

Question 14

LO 18.3: Demonstrate knowledge of the challenges associated with international real estate investing.

Answer 14

• Discuss three reasons why agency relationships are important in international real estate investing.
• Identify the sources and explain the implications of asymmetric information in international real estate investing.
• Describe the sources and effects of illiquidity and transactions costs in international real estate investing.
• Describe the political and economic risks associated with international real estate investing.
• Discuss and calculate exchange rate risk in the context of international real estate investing.
• Recognize legal risks encountered in international real estate investing

Question 15

3 Reasons why Agency relationships are important in unlisted int’l RE investing

Agents are important as both property managers and as investment decision makers.

Answer 15

1. Agent market is inefficient - for a given fee level, some mgrs will outperform others.
2. Investors lack the time and resources to efficinelty monitor mangers, so a solid relationship with managers is important and will lead to a greater allocation to int’l real estate. Especially true for direct investments where investors are unable to rely on large number of other LPs/investors to monitor manager.
3. Real estate mkts are inefficient, so investors often seek managers who can select investments that generate consistently superior risk-adjusted returns.

Question 16

Asymmetry of Information in Int’l RE

Answer 16

Some real estate markets are inefficient, and less informed traders are likely to earn inferior returns. In these cases, foreign investors should underweight int’l real estate.

Question 17

Explicit and Implicit Costs of int’l RE

Answer 17

illiquidity premium - due to inability to quickly and efficiently buy and sell assets

Acquiring and selling have signficant transaction costs, including:

• commissions
• legal fees
• property transfer taxes.

Commish and Legal can range from 2 to 7%, property transfer tax can range from 1 to 7% where it exists.

Question 18

Risks of Int’l Real Estate Investing

Answer 18

Political Risk - risk that political weakness, including regime changes, political instability, expropriateion, or ownership limits, could affect RE returns. (Crystallex)

Economic Risk - refers to the risk that economic conditions, icnlduing macroeconmoic factors such as monteary and tax policies and gov’t regs, can effect RE returns and risk. Limits can be place on repatraition of profits

Legal Risk - risk that RE is subject to encumbrances, lins, problems with the title, or illegality.

Exchange-rate risk - risk of currency movements between the forex of the local currency of real estate and other forex’s or the domestic currency. (contributes largest contributor to vol, generally).

Question 19

Formula for International RE Return

Answer 19

Question 20

Risk Formula for Int’l RE

Answer 20

An asset’s risk can be described as the risk of a portfolio of two risky assets:

Question 21

LO 18.4: Demonstrate knowledge of strategies for establishing a global real estate investment program.

Answer 21

• Discuss the advantages and disadvantages of international equity real estate investment trusts (REITs).
• Describe the advantages and disadvantages of various forms of real estate equity investments and debt investments.

Question 22

International REITs

Answer 22

• liquid equity-like investments that offer diversification benefits and avoid many of the risks that investors in direct real estate face
• Direct hedging can be costly, may rely on Natural hedge - especially effective if leverage exists, in local currency.
  *

Question 23

Two approaches to determining International REIT optimal weight

Answer 23

1. modern portfolio theory - Using the markowitz framework has signficant shortcomins, including lmited historical data and challenges applying historical data for determining weights for a specific period
   
   1. International Index Weights - Global RE indices typically underrepresent certain countries while overrepresenting other countries. Can remedy this by using index weights with a GDP adjustment

Question 24

Forms of Equity Investments in RE

Answer 24

1. Direct RE Investments - invest in physical RE without pooling or structuring, often in the form of JVs. Can target specific RE markets or prop types
2. Pooled Investemnts in Direct RE - Funds that directly invest in physical property - generate returns from rental income or cap gains. Offer greater liquidity than Direct RE, require less expertise. Less transparent than direct RE and less liquid than REITs
3. Listed RE Securities -invest in publicly traded RE entitiesand include REITs. Primary income is generated from Div’d income and cap gains. Offer diversivication benefits with strong levels of liquidity and transparency - correlation to equity markets are high, total return is lower because no liquidity premium.
   1.

Question 25

Forms of deb RE Investment

Answer 25

1. First-mortage claims - loans that have a first claim to underlying property in a bankruptcy or liquidation scenario - subject to interest rate risk and less liquid than REITs
2. Commercial mortgage-backed securities (CMBS)- pooled sec’s that invest in commercial mortgages. Total return is generated from interest income, and somewhat price appreciation. Segmented by risk (tranches), which offer credit enhancements an dbetter match each investor’s risk-return prefs. More liquid than direct mortgage ivnestments, and offer diversification, however market is less transparent
3. RE Mezzanine debt investments - hybrid instruments that invest in either direct RE or in pools of assets, and have equity and debt-like characterstics (subordinated debt or pref equity). Total return is primarily interest income. higher returns than CMBS but less liquid, greater credit risk
4. Corporate debt of REITs - debt securities issued by REITs. Investment in these sec’s can be direct or pooled. More liquid than other RE types but have greater interest rate and credit risk with higher vol.