Andrew Baum and David Hartzell, Global Property Investment, 2011 International real estate investment: 2

Andrew Baum and David Hartzell, Global Property Investment, 2011 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 = (.14*.6)/(1-.6) = /0.4 = 29% (approx.)

Andrew Baum and David Hartzell, Global Property Investment, 2011 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 = (.05*.6)/(1-.6) = 0.17/0.4 = 42.5% (approx.) What’s the catch?

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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?

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 High nominal returns in local currency – who are we? We maximise K + 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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?

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 Currency hedging 5.25% interest 4.25% interest UK Euro 8% return 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%

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 How do swaps work? InvestorBank Euro Sterling Investor agrees to sell € and take £ Margin? 1% on sterling – why?

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 Case: problems Income? Hedging costs –Margin and cash calls –Fees Uncertainty over sale price Uncertainty over sale timing

Andrew Baum and David Hartzell, Global Property Investment, 2011 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

Andrew Baum and David Hartzell, Global Property Investment, 2011 Should we hedge? FundFund CrncyAsset CrncyHedged?Exposure Fortress FundJPY No11% Secured Capital Loan FundUSDJPYYes10% Tokyo FundJPY No9% Altis Real Estate PartnershipAUD No9% AMP Wholesale Office FundAUD No5% Australian FundAUD No9% Other Developed FundUSDSGD/HKD/TWDYes9% China FundUSDCNYNo11% Goodman Hong Kong Logistics FundHKD No12% Prupim Property FundUSD Assets transacted un USD 8% Reserve7% Total100%

Andrew Baum and David Hartzell, Global Property Investment, 2011 A return comparison (1) Shopping centre, FranceShopping centre, UK Net rental income5.5%Net rental income5.0% Capital growth2.5%Capital growth2.0% Total return8.0%Total return7.0%

Andrew Baum and David Hartzell, Global Property Investment, 2011 A return comparison (2) €100m shopping centre with 50% leverage£100m shopping centre with 50% leverage €mReturn on equity £mReturn on equity Net rental income5.5Net rental income5.0 Management fees(0.5)Management fees(0.2) Interest(2.6)Interest(3.1) Net income2.44.8%Net income1.73.4% Capital growth2.5Capital growth2.0 Tax leakage(0.3)Tax leakage0.0 Total return4.69.2%Total return3.77.4% Hedging return1.0% Total return incl hedge10.2%

Andrew Baum and David Hartzell, Global Property Investment, 2011 A return comparison (1) Shopping centre, FranceShopping centre, UK Cash on cash yield4.8%Net rental income3.4% Capital growth2.5%Capital growth2.0% Leverage, costs1.9% L everage, costs2.0% Hedging effect1.0% Total return10.2%Total return7.4%