When hedging we must understand that the contribution of currency market fluctuations to return volatility varies significantly by location. Colin Butkus and Michael Hakim report

International investing creates exposure to foreign currencies. The more global the real estate investor becomes the greater the risks from adverse currency movements. Currency movements could of course prove beneficial to investors.

However, investors are concerned with exchange rate fluctuations which, if left unmanaged, can hurt portfolio returns. Investors have become more sophisticated through time and they make use of alternative hedging instruments. Hedging comes at a cost and an assessment of the merits of hedging is useful.

The benefits of hedged returns to the portfolio are studied in a similar way as unhedged returns. On the other hand an investor can take positions on expected currency movements and leave the returns unhedged to benefit from the expected favourable currency swings.

Total returns to the foreign investor reflect real estate market conditions and currency returns. It is valuable for investors to know the relative importance of currency or real estate market factors in the volatility of total returns and how this varies by country and sector. Even if returns are hedged evidence on this topic helps the investor assess the benefits of hedging.

In this article we provide findings on the impact of currency on the volatility of real estate returns. We take the perspective of a UK investor who invests in international offices. Our example contains 35 markets. We decompose the volatility of international office returns into the percentage of return volatility from movements in foreign exchange rates and that from the direct property investment.

The data series we require are total returns and exchange rates. Office returns are taken from PPR's proprietary global database. These returns are computed in local terms; they are the total return an investor of office buildings will realise in that country's local currency. For the purpose of this exercise, we have transformed those returns into UK sterling-based returns as well.

Historical foreign exchange rate data were acquired from Bloomberg. We calculated an average exchange rate for each quarter based on daily exchange rates. Now, taking the currency and local quarterly return series and multiplying them will yield the UK sterling return series.

The analysis implicitly assumes funds are repatriated quarterly.Recognising that returns from direct real estate and returns from foreign exchange movements are not perfectly correlated, we treated the volatility of sterling returns series as a ‘two risky asset' portfolio in which the volatility is not simply a weighted average of the volatilities of the direct real estate and foreign currency movements.

The covariance between the two series must be considered. For example, if the correlation between an international real estate market and the corresponding currency were negative, the volatility experienced by the UK investor would actually be less than the volatility experienced by a local market investor!

There is no single method that will establish the variance contribution weights and approaches vary from simple methods, such as division of variances to more complicated methods involving regression and principal component analysis. The methods can run in parallel to cross check results, the approach adopted in this analysis.

 The results of our analysis are shown in the figure. The cities are ranked by the largest contribution of the office market conditions to the volatility of total returns. In interpreting these results it is important that the graph is not a comparison of relative risk across markets but rather a comparison of where that risk comes from - either currency or real estate.

A number of observations can be made:

First of all there is an evident dispersion in the relative weight of currency and office market induced volatility in total returns. By investing in Mumbai offices a UK investor should expect that the volatility of the returns is much more prone to the local office market conditions. In contrast, if the UK investor has holdings in Brussels the volatility of returns on his office holdings is clearly induced by the movements in the sterling-euro exchange rate;
  In certain Asian markets (Hong Kong, Singapore and Beijing) nearly the full risk borne by UK investors is due to office market conditions. Again, in other Asian markets (Japanese and Shanghai to an extent) the opposite is true, currency swings play a greater role in total return volatility;
  Some European markets that have low commercial real estate volatility and therefore might be considered ‘core' markets, in fact have much higher levels of observed volatility to UK investors because of the currency impact. Brussels, Munich, Frankfurt and Copenhagen are falling into this category. So, for markets that are perceived safe/ low volatility in local terms may not translate to outside investors for its risk return profile. In other markets (Paris, Madrid, Geneva) office return volatility reflects market conditions to a greater extent;
  For the North American cities we included in the analysis and Sydney, UK investors should be aware of the volatility that can be induced by office market conditions.

There are several conclusions to be drawn from these findings. If UK investors hedge the sterling-dollar exchange rate their return can still be volatile from fluctuations in office market returns.

The same applies to the Chinese cities (with the exception of Shanghai), Sydney and Mumbai. It makes sense to hedge the sterling-yen exchange rate to reduce the volatility in the sterling-based office returns from Japanese, South Korean and Shanghai investments. The impact of hedging the sterling-euro movements on a European office portfolio will depend where these investments are.

Colin Butkus is a quantitative analyst in PPR's strategic research team

Michael Hakim is a quantitative analyst in PPR's strategic research team