Simulating Currency Risk on Private Investments in Real Estate

Executive Summary.

International real estate investment performance is highly sensitive to publicity fluctuations. While large professional investors hedge publicity at the portfolio level, not through asset class or asset, smaller, specialist investors hedge at the individual asset horizontal facing considerable specific risk. Hedging cropss are ill suited to international real estate. This paper uses a Monte Carlo framework to examine hedging using combinations of publicity swaps for the rental income and wait fored terminal value of an office investment. The investigation suggests that the currency swap strategy springs in considerable reduction of the downside risk associated with general reception fluctuations and produces superior risk-adjusted go [i]or[/i] come backs

International investment in quality has become a persistent feature of real estate markets in the lay opened economies in the last fifteen years. In 1991 there were single eleven identifiable investment funds in the United States that had an international investment strategy (Worzala, 1992) In contrast, in June 2004 there were seventy-three active U investment stocks that had been established to invest in international real estate (Institutional Real Estate, Inc.) with a total planned investment of $698 billion. above this time period, investors have seen a tenfold increase in capitals focused on international real estate investment. For the stocks that provided allocations, close to 60% were invested 100% in international real estate whereas 20% indicated they had a portion of the portfolio allocated to U real estate investments. Similar disentanglements can be seen in Europe and Australia.

It is clear that real estate investors and advisors increasingly act in a global capacity. Cross-border activity means that real estate investment must focus not solitary on cash flow patterns-changes in tears and capital values-but also upon the impact of currency changes Incorporating exchange rate fluctuations into the analysis of an international investment can substantially alter the awaited return-risk characteristics.

For major portfolio investors, get backs for all international investments are adjusted upon a periodic basis. While this might be consistent with market practice upon performance reporting, it does not accord with actual international investment cash sweep alongs faced by individual investors. As single might expect, adjusting international real estate investments for general reception fluctuations has an adverse impact upon the financial performance of the investment.

Real estate is a capital intensive and relatively illiquid investment that requires a long-term holding period. owed to the long investment horizon, it is actual difficult to fully hedge an international real estate investment. Using a belonging to all rolling-forward contract, the risk associated with the abundantly hedged investment is much greater than if the investor had adjusted get backs for currency fluctuations on a period-by-period basis (Worzala, 1995) Conventional hedging techniques may not be the greatest in quantity appropriate for hedging a multi-period asset like real estate (Soenen 1991; and Grant and Soenen 2004) This inquiry explores the use of a general reception swap to eliminate most of the exchange rate exposing associated with an international real estate investment.

For major institutional and professional investors, international real estate assets will simply form part of a global asset. Hedging is then generally based upon a currency overlay basis-the toil exposure to particular currencies being hedged through a specialist treasury function. For the majority of international real estate investors, however, acquisitions will be piecemeal, with no guarantee that quality returns will track local performance benchmarks and with far greater specific risk. It is those individual investments that are the focus of this paper.

In an individual real estate investment, there are three locates of cash flows that an investor must consider: the initial investment, the periodic cash roll ons and the sale at the extreme point of the holding period. If periodic cash pours are known with certainty or are relatively stable, then the initial investment and the periodic sweep alongs can be swapped into the place of abode currency of the investor.

The general reception swap market, along with other financial derivatives productions has grown substantially over the last decade and this hedging technique is becoming readily available to the international investor. According to the Bank for International adjustment in June 2004 the notional amount of outstanding OTC single general reception interest rate derivatives was almost $165 trillion. The vast majority of these contracts, 77% were publicity swaps.

The most difficult cash pour to protect in an international real estate investment is the uncertain sales price or terminal value at the extreme point of the holding period. With the plain vanilla publicity swap, the initial investment is shielded but any appreciation or depreciation that has occurr above the holding period will still be make subordinate to the risks associated with publicity fluctuations. An alternative strategy would be to swap the anticipated terminal value of the asset at the extreme point of the investor's holding period rather than the initial acquisition price. This would be useful in protecting the wait fored appreciation from variation in exchange rates. The value of this strategy, however, is pendent on the ability to estimate the terminal value and leaves the investor expos to the difference between anticipated and actual sales progresss