Although cross-border investment is an established strategy for equity portfolios, it is only now emerging as a fact of life in the portfolios of real estate investors. And while measuring the risks of real estate investment in the investor's home market may be straightforward enough, gauging risk in foreign markets can be fraught with difficulties.
Given the maturity of the property cycle in countries such as the US, international diversification has become an increasingly pressing matter for investors.
Economists at Chicago-based LaSalle Investment Management are urging US real estate investors with a "growth" or "value added" style to expand their exposure to overseas markets to some 15 to 20 per cent of all investments during the next three years.
EU fund managers with a similar investment style would be well advised to place 15 per cent of new allocations in the still-growing sectors of US real estate, and a further 15 per cent in the recovering markets of Central and Eastern Europe.
However, as LaSalle points out, the trickier question comes as investors are forced to make decisions about individual projects in each foreign country. What rates of return are needed to justify the risks of cross-border investment?
Jacques Gordon, head of research at LaSalle, notes that equities investors have long had to consider similar questions in diversifying share portfolios. "Country risk and currency risk information is widely available," he says.
However, property investment contains elements of risk which are not necessarily common to those of equities and quantifying these is much more difficult. In a recent research paper, LaSalle sets out what it regards as minimum "hurdle rates" of return which investors need to expect to earn in order to justify specific projects.
Mr Gordon broadly identifies two types of risk which investors need to assess in addition to the standard country and currency risk judgments. The first of these, he says, is market transparency. "By this we mean the ability to track transactions throughout the market," Mr Gordon says. "It is the ability to create an audit trail, the ability to be sure of prices paid."
The second, he says, are the risks peculiar to the local property market. "By this we mean such things as the ability to obtain clean title to a property," he says. In some markets, for instance, foreign investors may have much more difficulty than their domestic counterparts in foreclosing on loans or taking clean title to properties.
LaSalle is not alone in trying to quantify cross-border investment risks for real estate. Jappe deBoer, European sector director for property at ABN Amro, says the bank has been analysing precisely that question for its own European clients. "Our starting point is always: `What does the government do?'," Mr deBoer says. "The question is: What is the planning regime?".
Spain, for instance, he says, is a far riskier market than France, where the local planning authorities have all but forbidden new out-of-town shopping centre development. "The Spanish market is very risky because the planning regime allows for expansion of retail space at 17 per cent per year," he says. "If you know the planning regime, you know 80 per cent of the market."
MR Gordon argues that the hurdle rate at which cross-border investment in any given project becomes attractive must also take account of the risk-free rate of return on capital available in that country. Thus, a projected rate of return of, say, 15 per cent, in a country whose government debt is yielding 10 per cent, may not be sufficiently high to justify investment.
LaSalle has calculated country-specific hurdle rates for various markets, taking into account currency and country risk, transparency risk and fundamentals.
Perhaps not surprisingly, the US, UK and Canada require the lowest hurdle rates for investment at 4.5 per cent above the investor's own risk-free cost of capital. Thus, a US investor for whom a risk-free rate of return of 6 per cent is a reasonable assumption, would need to earn at least 10.5 per cent from a property investment in the UK.
The analysis throws up some interesting anomalies. Italy and Portugal, for instance, require hurdle rates of 15 per cent, before taking into account the risk-free rate of return, because transparency and local market fundamentals in both countries are relatively high. Spain, by contrast, with similar levels of country and currency risk, only requires a 10.5 per cent hurdle rate because both transparency and fundamentals involve lower risk.
However, Mr Gordon cautions that the hurdle rate analysis must take into account the riskiness of each individual project, and not only examine that of the general market. "A risky development deal in a semi-transparent property market in a less stable country adds layers of risk that may increase the hurdle rate," he notes.
Mr deBoer also notes that attempts to assess hurdle rates of return should hardly be restricted to direct property investment. ABN Amro is preparing research upon rates of return on capital in various European real estate securities markets.
THE research is incomplete but the data suggest that, in markets where real estate securities trade at discounts to net asset value, much higher rates of return on capital are needed to justify investment. Thus, in the UK market, rates of return of 7 to 8 are needed, while in the Netherlands, where securities trade at close to net asset value, returns of 4 to 5 per cent are required.
However, Mr deBoer notes that the ABN Amro research raises troubling questions about indirect property investment in Europe generally. "The riskfree rate of return in most European markets is about 5.5 to 6 per cent," he says. If the hurdle rate for investment is 7 per cent, investors may not be getting enough return for the risk they are taking.
"Property yields in Europe may be fundamentally too low," he says.
