CAIA L2 - 9.5 - Complexity and the Case of Cross-Border Real Estate Investing Flashcards
Formula
Total cross-border
real estate return
9.5 - Complexity and the Case of Cross-Border Real Estate Investing
9.5 - Complexity and the Case of Cross-Border Real Estate Investing
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
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
Explain
How to construct
a Natural Hedge
9.5 - Complexity and the Case of Cross-Border Real Estate Investing
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
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
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
Define
quanto future derivatives
9.5 - Complexity and the Case of Cross-Border Real Estate Investing
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
Formula
After-Tax Net Yield
(of real estate investing)
9.5 - Complexity and the Case of Cross-Border Real Estate Investing
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
List
Benefits
of International Real Estate Investing
9.5 - Complexity and the Case of Cross-Border Real Estate Investing
-
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. -
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
Complete
Investors who are tax-exempt
should ________________ tax-advantaged investments
9.5 - Complexity and the Case of Cross-Border Real Estate Investing
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
List
Challenges
in international real estate investing
9.5 - Complexity and the Case of Cross-Border Real Estate Investing
-
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) -
Information Asymmetries
RE properties are unique.
Buyers in informational disadvantage -
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 -
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
Sources of illiquidity when making the decision to invest in global real estate
- Private real estate is generally considered to be a very illiquid asset class given the highly unique nature of properties, most notably their location.
- Roundtrip costs can range between 2% and 10%, with property transfer taxes sometimes being a significant portion of the total. Higher roundtrip costs will generally lead to higher levels of illiquidity.
- The significant amount of time involved in negotiating contracts and sourcing deals, the latter of which may involve considerable amounts of searching and due diligence, contributes to increased illiquidity.
- Many private real estate deals are typically limited to large and fixed dollar investments in limited partnerships. The features of being large and indivisible may also lead to higher levels of illiquidity.
- Sometimes property owners contribute to illiquidity by refusing to sell for less than speci ied amounts, thereby increasing the selling time.
LO 9.5.7
Law of one price
The law of one price states that all assets should trade at the same price in all jurisdiction. In other words, currency-adjusted returns should be equal for identical assets traded in different countries. That holds true for securities with access to arbitrage. Real assets should trade at the same currency-adjusted price in all countries. If they did not, then arbitrageurs would exploit the pricing differential to return the prices to equilibrium.
Assumes no firctions such as taxes or trading costs
Occurs in a perfect market.
implication - in efficeint markets, hedging currency risk would not be required
In an imperfect market, the expectation is that purchasing power parity would move prices toward the result as if the law of one price held.
LO 9.5.2
In imperfect markets, purchasing power parity holds in:
The Long-Term only.
In imperfect markets, purchasing power parity is likely to result in similar assets having the same long-term returns.
LO 9.5.2
Price Stickiness
Price stickiness refers to the degree to which prices lag changes in the economy.
Wages, rents, and locally produced items are most likely to experience minor or no price changes in the short run only. They will most likely adjust in the long run.
