Should Asian investors target London, Paris and New York when going global? Not necessarily, Charlie Browne and Hans Vrensen show
Managing risk has become a key aspect of investment in real estate, especially as investors continue to allocate capital in their search for yield. As the global economic recovery has gained momentum, cross-border investment has been rising. Asian investors have become willing to invest outside their home markets and are confident that returns can be achieved there.
However, picking which markets to enter is a complex decision, both in terms of the investor’s strategy and the returns needed to compensate for the additional risk of expanding abroad. Historically, large international cities such as London, Paris and New York have been the first ports of call for Asian investors expanding abroad, and continue to be popular destinations. These markets offer high liquidity, a diverse range of assets, attractive pricing and accessible transport links.
Even so, these locations may not be the optimal choices when viewed from a portfolio analysis perspective. High levels of correlation between the individual assets in a portfolio is undesirable, as diversification will deliver no benefit in terms of reducing the volatility of returns. On the other hand, low or negative correlations are desirable as the assets contained in the portfolio will move less in synchronisation, thereby generating more steady returns. By selecting the optimal combination of markets to enter, investors can minimise their risk and reduce the volatility of their overall portfolio. Moreover, they can achieve the same return as that of a domestic portfolio, but at a lower level of risk. By way of example, we will apply this analysis to investors from South Korea wishing to expand their portfolios abroad.
Since 2009, South Koreans have invested $10.8bn (€7.8bn) outside of their domestic market. Of this, $5.7bn was allocated to Europe, making up more than half of their total international investment. Domestic investment fell sharply in South Korea in 2013. At the same time, international investment from South Korea rose, especially to Europe. Purchases in Europe made up 27% of the total domestic and international investment from South Korea in 2013 (figure 1). Europe is becoming more attractive as its economic recovery gathers pace, the prospect of a euro-zone split recedes and opportunities to gain excess returns become more prevalent.
Investment into Europe from South Korea is expected to continue for the foreseeable future as prime locations offer high liquidity and good relative value, supported by a strong financial and business services sector. However, strong demand for prime assets has priced many institutional investors out of these markets. As risk aversion continues to fall, we expect investors to seek opportunities in medium-sized locations where stock is relatively underpriced.
South Korean investors are typical of Asian investors, having expanded their allocations to property in the US and Europe over the past three years, with the most popular destinations being London, New York and Chicago. However, pricing for prime assets in these markets has changed significantly due to strong investor demand for safe assets in an uncertain environment.
As conditions improve and the direction of the European and US economies becomes clearer, we expect investors to seek opportunities in medium-sized markets where stock remains more attractively priced yet accessible. Considering this, on the basis of market size and liquidity we have identified the top seven office markets in each of Europe, Asia Pacific and the US where Asian investors might consider investing (table 1).
Risk, return and correlations between markets are the key factors that determine the locations that create a diversified portfolio with optimal risk and return characteristics. By applying modern portfolio theory, the locations that minimise risk can be identified and returns enhanced for Seoul-based investors wishing to expand outside of their home market.
Seoul offices are well placed in terms of risk and return compared with other markets. Although expected returns are relatively low, historically the risk of returns has been the lowest in Asia Pacific, and lower than any European market. By applying portfolio theory, it is possible for investors to reduce the risk of the overall portfolios without compromising returns through careful selection of markets that have a relatively low degree of correlation with the domestic portfolio. We assume that domestic investors in Seoul who wish to allocate capital outside their home market will begin by allocating 10% of their portfolios internationally. All the possible portfolios that can be achieved under this scenario lie within the ‘investable universe’ (figure 2). The optimal portfolio curve is developed, as represented by the red line, which indicates the portfolios that yield the minimum risk for any given level of return.
A rational investor based in Seoul would prefer any portfolio with less risk and/or higher expected returns then their current allocation. Knowing this, we can deduce that any portfolio above A and that lies along the optimal portfolio curve is preferable to all the other portfolios in the investable universe.
Exactly where along this curve an investor will choose will depend upon their specific risk/return preferences. For our analysis, we will assume that investors wish to minimise risk, and so will prefer portfolio A to any other possibility. In this case, for an investor previously invested only in Seoul, risk is decreased by almost 1% per annum and expected returns are enhanced by 0.5% per annum. This is achieved with a portfolio that is allocated 90% to Seoul, 1% to Milan and 9% to Beijing offices (figure 4).
Next, we assume that investors want to allocate 20% of their portfolios internationally. The investable universe expands as higher levels of international capital allow for a greater degree of diversification. The minimum risk portfolio in this case is represented by portfolio B. At this point, risk is reduced by 1.6% per annum and expected returns are enhanced by 0.8% per annum compared with a 100% Seoul-based portfolio (figure 3). The international portion of portfolio B is made up of 9% Milan and 11% Beijing offices.
The addition of Milan and Beijing to portfolios A and B is supported by the low correlations of their total returns with returns of Seoul (figure 5). Correlation is a key factor in selecting the markets that are included in the portfolio. Low or negative correlations between assets is preferred to high positive correlations because it results in more diversified returns and reduces overall portfolio risk. More specifically, the combination of two or more assets with a correlation of less than one will yield a portfolio with a standard deviation of less than the proportional risk of the assets included in the portfolio. The extent of risk reduction becomes greater, the smaller that the correlation coefficient is.
The total returns of London, New York and Chicago are all highly correlated with Seoul. This means that these markets would not add as much diversification benefit to the overall portfolio as Beijing and Milan. Hence, from a portfolio-analysis perspective the well-trodden route of London or Paris would not deliver the maximum diversification benefits.
However, over the past three years London, New York and Chicago were the top three destinations for Seoul-based investors. Of these three cities, London represented 62% of total foreign purchases of $3.1bn, while Chicago and New York represented 19% each. If we assume that new international investors followed this allocation strategy, and apply the allocations of either 10% or 20% internationally, we arrive at portfolios C and D. Although some diversification benefits can be achieved by investing in these markets, it is clear that in both cases the benefits are not as high as allocating capital to Milan and Beijing, as represented by portfolios A and B (figure 6).
We have applied the portfolio analysis to four other locations in Asia Pacific as well: China, Japan, Singapore and Australia (table 2). The results for these markets also show that the the likes of London and Paris do not deliver maximum diversification benefits.
Due to their low average correlations with other markets, Beijing, Seoul and Milan feature prominently in the preferred destinations for Asian investors. In fact, these three markets show the lowest average correlations with the other markets included in this analysis. As such, we would expect these markets to appear as the optimal destination for many other domiciles. On the other hand, a good proportion of US destinations show a high average degree of correlation with the other markets, suggesting that they would not offer as high diversification benefits as markets with a low average correlation (figure 7).
Asian investors have been increasing their purchases of property farther away from their domestic market. Although core markets in the UK, US and Germany offer liquidity and attractive pricing, supported by strong economic fundamentals, they are not optimal from a portfolio-analysis perspective. Furthermore, demand for real estate in prime locations has priced investors out of these markets and medium-sized locations are beginning to look more attractive as they offer reasonable liquidity and pricing.
The South Korean example shows that popular core markets may not offer the optimal diversification benefits to Asian investors looking to expand internationally. Using portfolio theory and assuming that investors want to invest either 10% or 20% internationally, we have shown that Milan and Beijing offer the optimal diversification benefits for South Korean investors.
The degree of correlation between the total returns of each market is a key consideration when constructing the optimal portfolio. Although Milan or Beijing might not demonstrate the highest expected returns or indeed the lowest risk, their correlation with Seoul has been relatively low. This characteristic offers investors more diversified and reliable returns when they are included in the portfolio.
On the other hand, prime locations such as London, New York and Chicago have demonstrated a relatively high degree of correlation with the total returns of Seoul. We have shown that because of this, allocating capital to these markets does not offer as much diversification benefit to a portfolio as allocations to Milan and Beijing.
In applying this analysis to other locations in Asia Pacific, Seoul, Milan and Beijing frequently appear as optimal destinations for international investors to reduce their risk. Their low average correlations with the other markets in the analysis supports their inclusion as optimal locations for investors to consider when constructing a diversified portfolio. In summary, Asian investors should consider breaking with tradition when taking their first steps abroad. Considering a broader investment universe will allow them to reap the maximum benefits that portfolio diversification can deliver.
Charlie Browne is senior analyst and Hans Vrensen global head of research at DTZ
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