CAIA L2 - 9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Question 1

Formula

Total cross-border
real estate return

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Answer 1

r+fx ≈ (V1−V0) / V0
= { [ V0 × (1+r) × (1+fx) ] −V0} / V0

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Question 2

Formula

Variance
of a foreign asset
(e.g. International Real Estate)
and
volatility for different correlations

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Answer 2

A foreign asset can be viewed as a 2-asset portfolio:

σ’d’^2 = σ’fx’^2 + σ’r’^2 + 2 cov(fx,r)
σ’d’^2 = variance of a foreign real estate investment return in domestic currency terms
σ’fx’ = variance of the foreign exchange rate
σ’r’ = variance of the foreign real estate asset in its own currency
cov(fx,r) = covariance of the foreign exchange rate and the foreign real estate asset’s nominal return

• covariance = 0 => correl = 0 (ρ(fx,r)=0) “uncorrelated”
  σ’d’ = √(σ’fx’^2+σ’r’^2)
• ρ(fx,r) = 1
  σ’d’ = σ’fx’ + σ’r’
• ρ(fx,r) = -1
  σ’d’ = |σ’fx’ - σ’r’|

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Question 3

Explain

How to construct
a Natural Hedge

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Answer 3

It involves borrowing in the same currency as the foreign asset,
which serves to cancel out any currency movements
as they would impact both the borrowing and the asset itself

Obs:
If the loan <100%, hedge <100% of currency movement

EXAMPLE: Constructing a Natural Hedge
Assume an investor in Great Britain plans to invest in U.S. real estate. She plans to hedge 100% of her currency exposure. Forecasting returns over three years, the investor projects a return of 1.2% per year on real estate properties in Great Britain and a return of 4.6% per year on real estate properties in the U.S. The interest rate in Great Britain is 0.50% and the U.S. interest rate is 1.25%. Calculate the expected hedging cost and the expected hedged return for the investor.

Answer:
Expected hedging cost

The expected hedging cost is equal to the interest rate differential between the target country (the U.S.) and the investor’s home country (Great Britain). The cost is equal to 1.25% − 0.50% = 0.75%.

Expected hedged return

The expected hedged return is equal to the real estate return in the target country less the expected hedging cost. The return is therefore equal to 4.6% − 0.75% = 3.85%.

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Question 4

In a trade of gold in foreign market
If the trader were to properly hedge the transaction, which risk(s), if any, would be hedged?

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Answer 4

Only asset risk would be hedged. Gold is an arbitrable asset that follows the law of one price. Any attempt to hedge currency risk may have the opposite effect of actually incurring the risk.

Spectrum of the Need for Currency Hedging
Arbitragable Assets => Currency hedging not required
Alternative Assets => Currency hedging may be required
Fixed Income Assets => Currency hedging required

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Question 5

Define

quanto future derivatives

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Answer 5

The quanto futures contract should produce a smaller return (than direct investment and the traditional futures contract) when the currency strengthens.
That is because direct investment and the traditional futures contract enjoy multiplicative returns.
On the other hand, the quanto futures experiences an additive return only because the payoff is in the domestic currency already and therefore, does not benefit from multiplicative effect.

Recommended if investor do not desire foreign currency exposure => quanto futures contract + collateral invested

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Question 6

Formula

After-Tax Net Yield
(of real estate investing)

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Answer 6

Total cost = purchase price × (1 + acquisition cost)
Yield on total cost = NOI / Total cost
Estimated after−tax net yield = yield on total cost × (1 − tax rate)

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Question 7

List

Benefits
of International Real Estate Investing

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Answer 7

1. The pursuit of alpha
   There is the possibility of realizing higher risk-adjusted returns, especially when emerging markets are seeing almost double the growth level of developed markets over the past few decades. Such growth leads to greater urbanization and the additional need for residential and commercial real estate.
2. Diversification enhancement
   In general, global investments offer exposures to different risk factors than domestic (home) country investing alone. Therefore, the lower correlations will add diversification to investor portfolios. Theoretically, the inclusion of global real estate should shift the efficient frontier upward because the investment opportunity set is expanded. The end result may be higher expected returns for a given level of risk.

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Question 8

Complete

Investors who are tax-exempt
should ________________ tax-advantaged investments

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Answer 8

investors who are tax-exempt should avoid (or underweight) tax-advantaged investments
because tax-advantaged assets usually have lower pretax expected returns than for those that are highly taxed

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Question 9

List

Challenges
in international real estate investing

9.5 - Complexity and the Case of Cross-Border Real Estate Investing

Answer 9

1. Home effect
   There are many localized regulations and nuances that provide informational advantages for domestic real estate investors relative to foreign investors (confirmed by researchers)
2. Information Asymmetries
   RE properties are unique.
   Buyers in informational disadvantage
3. illiquidity
   Unique properties
   High roundtrip costs ~2-10% transfer taxes
   Requires time to source deals, due diligence and negotiate
   Large and indivisible
   Foreign informational disadvantage
   Anchoring of sellers
4. Risks
   Political (tax, expropriations, zone ruling)
   Economic (monetary+fiscal policies, regulations, ownership restrictions)
   Legal (fraud - improper title transfers, unauthorized mortgages)

9.5 - Complexity and the Case of Cross-Border Real Estate Investing