1 / 29

290 likes | 499 Views

International real estate investment: 2. Currency: the carry trade. SWF interested in buying Turkish shopping centre Cap rate 12% Expected IRR 20% Turkish bond yield/interest rate 14% What is the leveraged return in Turkish lira? ke = [ka-( kd *LTV)]/(1-LTV) where

Download Presentation
## International real estate investment: 2

**An Image/Link below is provided (as is) to download presentation**
Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.
Content is provided to you AS IS for your information and personal use only.
Download presentation by click this link.
While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.
During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

**Currency: the carry trade**• SWF interested in buying Turkish shopping centre • Cap rate 12% • Expected IRR 20% • Turkish bond yield/interest rate 14% • What is the leveraged return in Turkish lira? • ke = [ka-(kd*LTV)]/(1-LTV) where • ke = return on levered equity • ka = return on unlevered asset • kd = cost of debt • ke = 0.2 - (.14*.6)/(1-.6) = 0.2 - 0.084/0.4 = 29% (approx.)**Currency: the carry trade**• SWF interested in buying Turkish shopping centre • Turkish bond yield/interest rate 14% • US bond yield/interest rate 5%; • Why not borrow US dollars to buy shopping centre? • What is the new leveraged return in Turkish lira? • ke = [ka-(kd*LTV)]/(1-LTV) • ke = 0.2 - (.05*.6)/(1-.6) = 0.17/0.4 = 42.5% (approx.) • What’s the catch?**Currency theories**• Absolute PPP • the purchasing power of different currencies is equalized for a given basket of goods – Economist Big Mac index • Relative PPP • the difference in the rate of change in prices at home and abroad - the difference in the inflation rates - is equal to the percentage depreciation or appreciation of the exchange rate • Monetary model of exchange rates • exchange rate = f(prices, interest rates, GDP) • demand for money = supply of money and price (exchange rate) moves to keep this in balance**Interest rate parity**• Interest rate parity is a theory which relates interest rates and exchange rates • The spot price and the forward or futures price of a currency incorporate any interest rate differentials between the two currencies • Interest rate differentials and expected currency exchange rate movements are directly related • Turkey interest rate 14%, US 5%, expected currency movement must be +9% in favour of dollar • US investor: 14% - 9% = 5% in Turkey, or direct 5% in US • Turkey investor: 5% + 9% = 14% in US, or direct 14% in Turkey**Fisher equation**• R = l + i + RP • Difference in interest rates = difference in expected inflation • Currency appreciation = difference in interest rates = difference in expected inflation • A higher inflation currency should depreciate relative to a lower inflation currency – and will have higher interest rates**So what is the catch?**• Turkish interest rate/bond yield 14% • US interest rate/bond yield 5% • Expected lira depreciation v dollar 9% p.a. • [2000: $0.80; 2010: $1.50 (9% depreciation p.a.)] • Impact on leveraged return?**Inflation, interest rates, currencies**• In practice interest rates, expected inflation rates and currency exchange rate movements may not be related in the short term • For example, in ‘carry trades’ investors successfully borrow low-yielding and lend/invest in high-yielding currencies and assets • This is effective in periods of global financial and exchange rate stability • Carry trade may increase value of higher interest rate currencies – in the short run**What decision rule should we use?**• Look for high nominal returns in local currency? • Subject to currency risk • What if market is risky? • Look for high nominal returns in domestic currency? • Requires forecast of currency exchange rate • What if market is risky? • Look for high ‘excess returns’ in domestic currency? • Requires forecast of currency exchange rate • What does risk premium cover? • Look for high ‘excess returns’ in local currency? • Adjusts for market risk • Takes out currency effect**Required and expected returns**• Required return • IRR = RFR + Rp (risk free rate plus risk premium) • Expected return • IRR = K + G (cap rate plus appreciation) • Buy when K + G > RFR + Rp**High nominal returns in local currency – who are we?**• We maximiseK + G • But (1): a high return market is subject to expected currency depreciation and currency risk • G is partly inflation • Inflation produces weak currency • If exchange rates stay stable we win, especially if we use low cost leverage, and we can also part-hedge by using more expensive, local debt • But (2): a high return market is subject to high property risk • IRR = RFR + Rp • If we like taking risk - we are an opportunity fund**Dealing with risk**• We need to deal with currency and property risk • Estimate the required risk premium (RP) • Maximise the excess return: (K + G) – RFR – RP • K + G = IRR • So maximise IRR – RFR – RP**Dealing with risk**• Example: Turkey – assume 8% RP, 14% RFR • Maximise excess return: IRR (K + G) – RFR – RP • (K + G) = 12% cap rate (K) + 8% growth (G) = 20% IRR • IRR – RFR – RP = 20% - 14% - 8% = -2%: SELL • Example: US – assume 4% RP, 5% RFR • Maximise excess return: IRR (K + G) – RFR – RP • (K + G) = 8% cap rate (K) + 2% growth (G) = 10% IRR • IRR – RFR - RP = 10% - 5% - 4% = 1%: BUY**Dealing with risk**• Does this deal with currency? • Maximise (K + G – RFR) – RP • Inflation drives both G and RFR and cancels out • Does this deal with currency? Yes • Does this deal with property risk? • Maximise (K + G – RFR) – RP • RP is higher for risky properties • Does this deal with property risk? Yes**High excess returns in local currency? Who are we?**• We have to estimate the required risk premium (RP) • We then maximise the excess return: IRR – RFR – RP • We are a sophisticated, risk-averse property investor • We are a core fund**What should we optimise? Example**• High nominal returns in local currency? • Expected IRR in Turkey 20%, expected IRR in US 10% • High nominal returns in domestic currency? • Expected IRR in Turkey, US dollars, 11%, expected IRR in US 10% • High excess returns in domestic currency? • Expected IRR in Turkey, US dollars, 11% - but required return? • US: (K+G) – RFR - RP = 10% - 5% - 4% = 1%: BUY • High nominal excess returns in local currency? • US: (K+G) – RFR - RP = 10% - 5% - 4% = 1%: BUY • Turkey: (K+G) – RFR - RP = 20% - 14% - 8% = -2%: SELL**Should we hedge?**• Invest unhedged • Random walk? • Use local debt • Loan and property value both denominated in local currency • 70% debt is a 70% capital value hedge • But introduces leverage (and Turkish rates are high) • Use a currency overlay • Focus on real estate returns • Hedge the equity • Use currency futures • Get paid for reducing risk?**Case: UK to Europe**• Expected return on Europe 8% (6% income, 2% capital) • Expected return on UK 8% (6% income, 2% capital) • Base rate Euro 3.25% • Interest rate UK 4.25% • Margin over base rate 1% • Five year hold • UK investor • Current exchange rate €1.25: £1 • Property value £8m/€10m**Currency hedging**Euro UK 8% return 8% return 5.25% interest 4.25% interest • Interest rate difference means inflation expectations different; lower inflation expectation means Euro is expected to appreciate • Interest rate parity means selling Euro forward for £ earns an annual payment equal to the interest rate difference, i.e. 1%**Case: UK to Europe**• Expected value of property in 5 years: annual growth expected is 2%, so €10m * (1.02)^5 = €11.04m • What is the value of €11.04m in £? €11.04m/1.25 = £8.83m – but the exchange rate is expected to change • The Euro is expected to appreciate by 1% each year • Expected value of €11.04m in sterling? (€11.04m*(1.01)^5)/1.25 = £9.28m • So could let currency bet ride and get a capital return of £9.28/£8 = 1.16 = 1.03^5 = 3% p.a. • 3% capital return comes from 2% property, 1% currency - but this is subject to exchange rate risk**How do swaps work?**Euro Investor Bank Sterling Investor agrees to sell € and take £ Margin? 1% on sterling – why?**Case: UK to Europe**• Investor is long € - he has a property worth €11.04m • Sell €1.25 one year forward for £1.00 • Bank expects to pay a margin of 1%, so property investor will get £1.01 for €1.25 • For a five year swap he will get £1.01^5 = £1.051 • So he sells the property for €11.04m, swaps € for £ at €1.051, and gets €11.04m*1.051*.8 = £9.28m • Capital return is again 3% - £9.28m/£8.00m = 1.16 = 1.03^5 • This time, no currency risk**Hedging: using forwards**• Invest £ in € fund at day 1: switch £10m for €12.5m (1.25) • Hedge currency movements by using one year forwards (commitment to sell € for £ at a fixed exchange rate) • Forward exchange rate will be determined by spot rate (1.25) plus interest rate differential (1%) = 1.26 • In one year’s time, assuming no capital appreciation, we have a building worth £10.1m, if € has appreciated by 1% • £10.1m is the new amount to be hedged – the bank has £10m, so £100,000 cash is now needed**Case: problems**• Income? • Hedging costs • Margin and cash calls • Fees • Uncertainty over sale price • Uncertainty over sale timing**Should we hedge?**• Simple case – investor, building • Less simple case – investor, fund, building • Complex case – investor, fund of funds, fund, building • Example: £ investor; $ denominated fund of funds; Real denominated Brazil/South America shopping centre fund; Buenos Aires asset

More Related