Monday, June 16, 2008

Foreign investors must do a lot of homework...

After our last post about foreign buyers jumping into U.S. commercial real estate I began thinking about the variables at work driving their decisions. In addition to real estate fundamentals such as occupancy levels, rent trajectories, and new supply competition, foreign investors must also take into account currency exchange rates and changes in U.S. interest rates which affect real estate returns and exchange rates. Varying levels of structural risk across borders also come into play when seeking the highest risk-adjusted returns.

The most subjective of these factors may actually be the one that's easiest for international investors to assess - structural risk. While difficult to measure empirically, most investors intuitively consider the United States a very low-structural-risk investment environment due to our well-regulated, liquid, and long-established markets. This perception of low risk is evidenced by the fact that China, while criticizing U.S. economic policy, continues to hold most of its $1.76 trillion in foreign reserves in U.S. dollars as opposed to Brazilian Real or even Japanese Yen.

Exchange rates are trickier. To many foreign investors dollar-denominated assets must look like historic bargains right now as the dollar sits near low-water-marks against many foreign currencies (see historical chart of the NYBOT US Dollar Index below). However, if the dollar continues to weaken long-term, buying dollar-denominated real estate could be a disaster for global buyers.

After considering structural risk and current exchange rates, foreign investors still have one more piece of homework to do. They must make a careful bet on the trajectory of U.S. interest rates. If recent inflation-focused comments by various Fed officials are any indication, monetary policy could soon become less accommodative. If foreign investors foresee the Fed raising rates in the future, investment in the U.S. may look good from a currency speculation perspective, but the prospect of higher nominal interest rates could still point them towards waiting out the downturn before investing in American real estate.

This myriad of complex and interrelated decision drivers helps to explain why some foreign investors seem to think it's a great time to pour money into American assets (like Florida condos) while others are happy to sit on the sidelines and watch. What do you think they should be doing?

Llenrock Group

1 comment:

Llenrock said...

A Comment via Email from Ted:

Some good points, but this argument/approach may ignore three factors fueled by globalization of the U.S. commercial RE investment world. 1) The debt market in the U.S. is already tied to, and may become more correlative to international indices such as LIBOR, etc. 2) International investment begets international investment, i.e. the currency exchange may be mitigated by an international owner selling to another international owner, where cash flows are converted at spot rates over time. Both of these factors will not, of course, mitigate severe volatility in the currency exchange rates, but they will dilute the effect of moderate or predicted dynamism in currency markets. 3) The hedge/speculation factor can be just as viable in real estate micro-markets as in the oil market. Internationals or even large internationally exposed domestic firms will still invest in real estate assets with anticipated short-term currency value erosion or inversely correlated assets to offset other regions or other asset classes purely out of a need to diversify investments. The more globally institutional the investment capital, the more likely that this may skew pure exchange rate driven stagnancy or feeding frenzies depending on the particular movements. In summation, while there is clearly an argument to be made regarding the movements of the dollar in terms of real estate investment strategy, it will take major movements to realize any tangible effect.