Currency Adjusted Real Estate Indices​

Whitepaper Currency Adjusted Real Estate Indices

Julian Roche

Chief Economist

Realism in international real estate investment currency exposure International real estate investors are inadvertent currency speculators, facing currency risk from unhedged investments. As a result, they receive two returns: the performance of the real estate asset itself, plus the return on the currency used to purchase the security. Currency volatility can be significant, and the return from the currency can sometimes swamp the gain or loss on the foreign security.

It is hard to disagree with the assertion that ‘Because global real estate portfolios contain assets influenced by different national economies, with very different drivers, growth rates, and risk, the correlation of total returns between assets in these markets can be very low’1. However, the effect of currency adjusted is considerable. The Australian Dollar, for example, is a relatively volatile currency, with its value strongly correlated with commodity prices, and capable of daily movements of up to 1% either way. The authors compared an optimal global portfolio (on the efficient frontier in terms of returns vs risk) with a US portfolio, and found that it would have outperformed by a colossal 171%. But this outperformance is overstated if the effect of exchange rate movements is considered. The outperformance is still visible, but it falls to 92%, a difference that every investor should regard as very significant.2 The effect of falls in local currency against the USD are the most obvious recent example, especially for countries such as Nigeria and Egypt that have experienced both very rapid and considerable declines.

Experienced local investors in both those countries have in recent decades sought to balance their exposure to their national currency with USD investments, whether in the Gulf or the USA itself.

The Russell Group’s Conscious Currency™ investment approach concludes that investors should measure and model currency as a separate exposure set, based on the behaviour of specific currency markets. Crucially, in this approach, ‘investors need not believe that currency is an asset class, nor that it has a positive long-term return: they simply need to believe that a better description of portfolio risks will generally allow better management of those risks’3. This entire approach is in marked contrast to a ‘diversified currency’ investment approach, which largely makes the heroic assumption that investors are of sufficient size to diversify adequately as to minimise currency risk, despite the fact that ‘for investors with only limited capital to deploy a currency diversification strategy via a large portfolio of properties might not be an option’4. Such an investor would be well advised to attend to the Russell Group’s recommendation.

1 Hastings, A. and Nordby, M. (2009) Benefits of Global Diversification on a Global Portfolio. Journal of Superannuation Management 3(1) 73-82. Available at: https://www.fssuper.com.au/media/library/CPD/PDFs/Journals/FS_Super/Volume%203/Number%201/JSM_v3n1_Hastings_09.pdf Retrieved 21 May 2019. P.73 2 Ibid..

3 Russell Group (2019) Currency Overlay. Available at: https://russellinvestments.com/nz/solutions/implementation-services/currency-management/currencyoverlay Retrieved 17 May 2019.

4 Bejol, P. and Livingstone, N. (2018) Revisiting currency swaps: hedging real estate investments in global city markets. Journal of Property Investment & Finance 36(2), 191-209, p.192.

Why it matters: an example Suppose the Avatar real estate company which both accounts and funds itself in UAE dirhams (AED) were to have decided to make a development investment in a country outside the region – let’s call it Kommodistan – in 2014.

Here is what happened to the exchange rate between the Kommodian Stellar (KŜ) and the AED since then. Evidently the Stellar has suffered both from the appreciation of the USD and the dependence of the Kommodian economy on commodity prices.

2.5 2.0 1.5 1.0 0.5 2015

2016

2017

2018

2019

To understand the consequences of this change in exchange rates for international real estate investment, let us use a simplified annual model where all of Avatar’s investments are made at the end of December 2013. Let us further assume that Avatar’s cost of capital, the amount it must make on its investments to break even, is 10%.

Suppose the cashflows in local currency were projected as follows: 10% Discount rate

KŜ

Year Cash flows

2014 -1,000,000

2015 250,000

2016 300,000

2017 500,000

2018 500,000

DF

1

0.91

0.83

0.75

0.68

Discounted Cash flows

-1,000,000

227,273

247,934

300,526

341,507

NPV

117239

Avatar could look forward to a return of 12% on its original investment, and a positive Net Present Value of KŜ117,239. If Avatar had presumed no change in the value of the KŜ relative to the AED, then the original investment of AED1,527,449 would have produced an NPV of AED184,585.

But the exchange rate between the two did change – a lot. One KŜ converted to AED at the following rates on each December 31:

2018

0.694034

2017

0.968773

2016

1.044233

2015

1.258697

2014

1.574429

If we now restate the results in AED, they look very different indeed. What would have been a successful investment has because of the depreciating KŜ been turned into a catastrophe.

10% Discount Rate

AED

Year

2014

2015

2016

2017

2018

Cash flows

-1,574,429

314,674

313,270

387,509

347,017

DF

1

0.91

0.83

0.75

0.68

Discounted Cash flows

1,574,429

286,068

258,901

291,141

237,017

NPV

-501,302

Avatar has been adversely affected on two fronts: one, because the KŜ has fallen, the value in AED is less; and secondly, because the positive cashflows are back-ended, as they inevitably are in any real estate development that is not pre-sold. The decline in the value of the KŜ has had a progressively worse effect over time. If the investment had continued on into 2019, the chart above tells us that nothing much would have improved.

One final look at Avatar’s project. What cashflows in KŜ would have been needed to generate the same return that was originally projected? The answer below – a required rise of 58% in cashflow - shows how unrealistic any expectation is that local prices will rise to compensate for any currency fall.

10% Discount Rate

AED

Year

2014

2015

2016

2017

2018

Cash flows

-1,574,429

496,859

494,642

611,863

547,927

DF

1

0.91

0.83

0.75

0.68

Discounted Cash flows

1,574,429

451,690

408,795

459,702

374,242

NPV

120,000

Cash flow multiplier

1.58

Revised Cash flows

-1,000,000

394,741

473,689

631,586

789,482

Currency Adjusted Real Estate Indices All existing international real estate performance indices are expressed in local currency4; some chartered surveyors publish time series in USD as well, but they are market indicator numbers not transaction-based indices. It is possible to cross-multiply real estate prices with currencies manually, but it is a relatively laborious process to have to undertake every time an international investor wants to calculate their currency adjusted returns over time, and not every smaller or individual investor has currency data immediately to hand.

Cavendish Maxwell has therefore sought to improve investor understanding of returns in the UAE market for international investors by presenting those returns in local currencies. The resultant Currency Adjusted Real Estate indices enable instantaneous comparison of returns.

The starting point for the new indices will be the Property Monitor indices for the UAE. For the purposes of this whitepaper, I have used the overall house price performance index, both for apartments and villas. In AED, the track looks as follows:

APARTMENT June 2016 AED 2,037,954

2,200,000 2,150,000

PRICE (AED)

2,100,000 2,050,000 2,000,000 1,950,000 1,900,000 1,850,000 1,800,000 1,750,000

Sept 2016

Oct 2016

Nov 2016

Dec 2016

Jan 2017

Feb 2017

Mar 2017

Apr 2017

May 2017

Aug 2018

Sept 2018

Oct 2018

Nov 2018

Dec 2018

Jan 2019

Feb 2019

Mar 2019

Apr 2019

Aug 2016

Jul 2016

Jun 2016

May 2016

Apr 2016

Mar 2016

Feb 2016

Jan 2016

Dec 2015

Nov 2015

Oct 2015

Sept 2015

1,700,000

VILLA/TOWNHOUSES 5,700,000

April 2018 AED 5,178,091

5,600,000 5,500,000 5,4700,000

5,200,000 5,100,000 5,000,000 4,900,000 4,800,000 4,700,000 4,600,000 4,500,000

Jul 2018

Jun 2018

May 2018

Apr 2018

Mar 2018

Feb 2018

Jan 2018

Dec 2017

Nov 2017

Oct 2017

Sept 2017

4,400,000 Aug 2017

PRICE (AED)

5,300,000

Next, the graphs below show what has happened to the currencies of the key markets for the Currency Adjusted Real Estate indices in terms of the USD and therefore the AED. INDIA

PAKISTAN

21.00

50.00

20.00

40.00

19.00

30.00

18.00

20.00

17.00

10.00

16.00 1/01/2016

1/01/2017

1/01/2018

1/01/2019

1/01/2016

UNITED KINGDOM

1/01/2017

1/01/2018

1/01/2019

CHINA 1.95 1.90 1.85 1.80 1.75 1.70 1.65 1.60

0.25 0.20 0.15 0.10 0.05 1/01/2016

1/01/2017

1/01/2018

1/01/2019

1/01/2016

1/01/2017

1/01/2018

1/01/2019

CANADA

EGYPT 6.00 5.00 4.00 3.00 2.00 1.00

0.40 0.38 0.36 0.34 0.32 1/01/2016

1/01/2017

1/01/2018

1/01/2019

0.30 1/01/2016

RUSSIA 330.00

20.00

320.00

15.00

310.00

10.00

300.00

5.00

290.00 1/01/20171

1/01/20181

1/01/2018

1/01/2019

/01/2018

/01/2019

IRAQ

25.00

1/01/20161

1/01/2017

1/01/20191

280.00 /01/2016

/01/2017

Source: Yahoo Finance The charts above deliver the truth of international currency volatility since 2016. Compared to the effect of Egyptian and Iraqi devaluation, Brexit, tension with Russia, and the troubles of the Pakistani budget are relatively small. Noticeably too, intra-year volatility is higher for Canada than it is for Pakistan or Russia.

Now putting the two together, here are the charts for the Currency Adjusted Real Estate indices for Dubai apartments and villas over the same period:

DUBAI APARTMENT IN UK STERLING 500,000 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000

3/1/2019

1/1/2019

11/1/2018

9/1/2018

7/1/2018

5/1/2018

3/1/2018

1/1/2018

11/1/2017

9/1/2017

7/1/2017

5/1/2017

3/1/2017

1/1/2017

11/1/2016

9/1/2016

7/1/2016

5/1/2016

3/1/2016

1/1/2016

0

A rational strategy The evidence of Cavendish Maxwell’s Currency Adjusted Real Estate indices is that real estate returns are as the Russell Group expects for equities, heavily influenced by currency movements. As the US Federal Reserve stops their program of quantitative easing and increases interest rates – gradually, to be sure – the strength of the USD has been marked. The net result has been that in local currencies, investment in USD-denominated markets has been far more successful than the local market performance would itself indicate. The actual results in local currency are indicated by the Currency Adjusted Real Estate indices, and in recent years, unhedged investors in Egyptian pounds and Iraqi dinars will have profited considerably by the fall in their currency against the USD to which the AED is pegged.

This is not to suggest, however, that an unhedged investment strategy is either appropriate or even for the most part even sensible, as the Avatar example above demonstrates. There are a number of alternative strategies that real estate companies have adopted in practice to mitigate currency risk, ranging from the ineffectual to the cautious. The most risk-averse is that of currency hedging. The logic of eliminating some or all of the foreign exchange volatility from holding international assets is impeccable, and the methods well-known and readily available to all but a small minority of international investors. A currency swap would – at the price of introducing credit risk – eliminate the currency risk, at least of the initial capital, hedging the terminal value being inherently difficult to achieve because of uncertainty5 6. The effect is to produce a floor below which the exchange rate cannot travel. This in turn prevents any reduction in the Internal Rate of Return (IRR) of the investment as a result of currency movement, albeit at the cost of reducing the overall performance of the investment. The price of the swap should therefore be factored into the Discounted Cash Flow model. The resultant currencyadjusted return using a swap should be regarded as the benchmark return for comparison both with alternative risk management strategies, and with alternative local investments.

5

See Johnson, R., Lizieri, C.M., Soenen, C.M. and Worzala, E,M. (2006) Simulating currency risk on private investments in real estate. Journal of Real Estate Portfolio

Management 12(2), 91-101 for a worked example 6

See also Bejol, P. and Livingstone, N. (2018) Revisiting currency swaps: hedging real estate investments in global city markets. Journal of Property Investment & Finance

36(2), 191-209 for a further worked example for a Swiss investor.

The most logical strategy, however, is less extreme and allows for the retention of some currency risk. This would be for international investors to buy put options in the local currency vis-à -vis their domestic currency. The question remains as to what strike price the option should be bought for – in my opinion, it should be at that point where sensitivity analysis indicates that the IRR will have reduced to the investment cost of capital . Such an approach is more risk-averse than developing a hedge ratio, whereby the investors determine what percentage of their portfolio is hedged, but less so than the swap outlined above. It also has the advantage of showing actual returns for each investment and avoiding the possibility of cross-subsidisation if some investments are hedged and not others.

In the future, no one will ignore currency when they buy property.

The time between Johnson et al (2006) and Bejol & Livingstone (2018) saw increasing international investment in real estate, especially by individuals in residential properties. The UAE, and Dubai in particular, have been at the forefront of the international trend to acquire villas and apartments abroad.

Yet the currency impact of investment has been poorly understood until now. The Cavendish Maxwell Currency Adjusted Real Estate indices should become the go-to resource for existing and potential international investors in the UAE real estate market to remedy that deficiency, using them to devise appropriate strategies to mitigate currency risk.

7

Either the WACC or cost of equity, depending on whether the project is locally funded or not

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