Currency Risk – The Unwanted Child: IPF Report on Managing FX Exposure in Real Estate Investing
24 Jul 2018
Real estate investors seeking the wider choice, increased liquidity and higher returns that may be achievable outside their domestic market are discovering the unwanted child of cross-border investment: currency risk.
In an increasingly globalised real estate investment market, the potential for exchange rate fluctuations to impact the returns on international investments deserves greater investor focus, according to a recently released IPF report. In extreme cases, changes in exchange rates – which can be volatile and unpredictable – can dominate the real estate returns investors are seeking from their non-domestic investments. The published study, conducted for the IPF by the University of Cambridge, analyses market practice in the management of currency risk and comes up with some blunt conclusions, including that some managers show a bias away from managing currency risk where hedging is costly and currency management may be used selectively to boost returns as much as to control risk.
Around four-fifths of managers and investors surveyed hedge some or all of their currency risk and around 70% of these have a formal currency hedging policy but, even where clear procedures are in place, exceptions may be made.
Forward contracts are favoured for their simplicity and flexibility and are the most common hedging instrument but swaps, options and local leverage are all used extensively.
Currency hedging is frequently a treasury function rather than one undertaken jointly by central and real estate teams, giving rise to the risk that real estate fund managers may not be fully appreciating the potential impact of currency risk on their portfolios. Further, where leverage is increased to reduce foreign exchange risk, this may result in property market and finance-related risks being amplified.
The research concludes that the approach the real estate investor or manager adopts to manage currency risk should be highly focused on their circumstances and recognise, amongst other things, tolerance for different types of risks, domicile, outlook for specific markets, and hedging costs. Access to live market data is crucial, with anecdotal evidence that there can be substantial cost implications if a competitive process is not followed when hedging.
David Dix, Senior Director, Investment Advisory at CBRE Capital Advisers Ltd., and a member of the Project Steering Group that oversaw the research commented: “As cross-border, multi-currency real estate investment becomes more common, it’s crucial that investors develop a deeper understanding of the fundamental drivers of currency exposure and the tools that are available to manage foreign exchange risk. There’s no one-size-fits-all ‘solution’ to this challenge, but some prudent planning and action should allow investors to get back to focusing on the real estate and unlocking the opportunities they’re seeking.”
Nick Mansley of the University of Cambridge research team said: “Managers and clients need to be clear and honest about who is managing currency risk, the approach taken to how currency risk is managed and what flexibility there is in this approach. The research highlighted the many considerations involved and the need for specialist expertise as well as recommending that the extent to which currency risk management has removed the impact of currency movement in line with expectations should be monitored on a regular basis.”
A summary of the report, Managing Currency Risk in International Real Estate Investment, and two page At a Glance may be downloaded without charge from the IPF website: www.ipf.org.uk. The full report, currently available to IPF members and Research Programme Sponsors, will be free for non-members to access from September 2018.