THE RISING COST OF CURRENCY HEDGING AND ITS IMPACT ON U.S. COMMERCIAL REAL ESTATE MARKETS JULY 2018

71%of foreign investors hedge their currency risk from cross-border investments.1

1. Snapshot Research: The Impact of Currency on the Performance of European Non-listed Real Estate Funds. February 2017, INREV, www.inrev.org.

When investing in U.S. real estate, foreign investors must decide if they should hedge currency risk. In fact, a 2016 survey by INREV (European Association for Investors in Non-Listed Real Estate Vehicles) found approximately 71% of survey participants hedge their currency risk from cross-border investments.1 More recently, however, an increasingly volatile currency environment, combined with historically low interest rates in many countries around the globe (relative to the U.S.) has caused hedging costs to rise to abnormally high levels. Consequently, both foreign and domestic investors are questioning the impact hedging costs could have on the U.S. real estate markets.

This research paper will address the following questions:

1 Why are hedging costs so high today?

2 What does history tell us about the current hedging conditions?

3 What is the near-term outlook for hedging costs?

4 Should foreign investors hedge at all?

5 How has the U.S. Dollar trajectory impacted hedging decisions?

6 What are the U.S. commercial real estate implications given these rising costs?

USAA REAL ESTATE – RESEARCH REPORT 1

2. Ram, Kondo, Why Cross-Currency Basis Swaps Are Year-End Focus: Quick Take Q&A. December 15, 2017, Bloomberg, www.bloomberg.com

3. Chang, Cross Currency Basis – What is It? And What are the implications?. December 29, 2017, Bond Vigilantes, www.bondvigilantes.com.

4. The FX Dilemma: An Introduction to Hedging Currency Risk in Portfolios. January 2018, PIMCO, www.pimco.co.uk.

For foreign real estate investors looking to hedge U.S. Dollar assets, the cost of currency hedging has increased tremendously. Hedging costs for the USD to EUR, for example, were minimal in early 2014 and are now upwards of 200 to 300 basis points today, as shown on Exhibit 1. Such a substantial increase raises the question: why have costs risen so high? Three main elements drive hedging costs as described in the following:

A Short-term Rate Differential: The cost of hedging currency exposure is related to the interest rate differential between the U.S. and the other currency’s country or region, known as the cost of carry. As highlighted in Exhibit 1, the spread between U.S. one-month government bond rates versus other countries has widened in recent years, causing hedging costs to increase.

A Transaction Cost: These costs vary based on the type of hedge and frequency of implementing the hedge. For example, rolling over hedging contracts more often provides a better hedge (i.e., less basis risk), but this approach also incurs higher trading costs.

A Cross-Currency Basis: In general, the cross-currency basis is a measure of Dollar shortage in the market. For example, to hedge risk, a European investor enters into a one-year EUR/USD currency swap with a market counterparty, agreeing to swap a certain number of Euros for U.S. Dollars at today’s spot rate in one year’s time. In theory, the European investors will need to pay back U.S. Libor as interest in exchange for Euribor from its counterpart. However, in practice, whenever there is a higher demand for the Dollar, the counterparty lending the Dollar will ask for an additional price premium, which is referred to as the cross-currency basis. 2, 3

Hedging costs have increased in recent years. Using USD to EUR as an example, the differential between the Dollar and the Euro reflects the diverging Federal Reserve and European Central Bank (ECB) monetary policies. Also, the cross-currency basis has remained negative due to strong net demand for Dollars globally. In effect, accelerating short-term interest rates in America and a healthy market for the Dollar has increased hedging costs of U.S. assets for foreign investors.

1 Currency Hedging Costs are on the Rise

-6

-4

-2

0

2

4

6

8%

‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14 ‘15 ‘16 ‘17

Source: Bloomberg as of 31 December 2017 USD and EUR short-term rates are represented by 1-month USD Libor and 1-month Euribor respectively

Short-term rate differential FX basis EUR short-term rate USD short-term rate Total hedging cost

Exhibit 1: Decomposing Currency Hedging Costs (USD to EUR) 4

8%

6

4

2

0

– 2

– 4

– 6’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17

Source: Bloomberg as of 31 December 2017USD and EUR short-term rates are represented by 1-month USD Libor and 1-month Euribor, respectively

2 THE RISING COST OF CURRENCY HEDGING – JULY 2018

Hedging costs are expensive today, but similar conditions have also occurred in recent history. As noted in Exhibit 1, hedging costs soared in 1999-2000 and 2005-2006, as the Federal Reserve raised short-term rates faster than most other central banks. It is worth noting that interest rates, as well as commercial real estate cap rates, were significantly higher during the two previously-noted periods than they are today. Consequently, a 200 to 300 basis point hedging cost would have been more manageable when core real estate cap rates were around 7.5-9.5% and 5.0-7.0%, as was the case in 1999-2000 and 2005-2006, respectively. As of first quarter 2018, however, cap rates are near historic lows around 4.8%, suggesting there is little room to absorb high hedging expenses.5 Therefore, U.S. real estate may not be as attractive to some foreign buyers given the drag on returns.

If the historic USD/EUR currency relationship is any indication, these cycles tend to be short-lived; however, the situation may be different this time. In fact, conditions may worsen before they improve given the divergence in monetary policy of the U.S. compared to almost the entire developed world. Hedging costs are indeed a direct function of the difference between U.S. interest rates and the interest rates of foreign central banks, such as the ECB. The total hedging expense, however, is also impacted by interest rate expectations. For example, the Federal Reserve forecast currently suggests at least one more rate hike in 2018 (on top of the March and June rate increases) and potentially another three increases in 2019. If market participants expect U.S. interest rates to accelerate (e.g., four rate hikes in 2018 and 2019), while the ECB’s monetary policy outlook remains flat, then hedging costs will rise accordingly between the U.S. and the Euro. Ultimately, hedging costs are a reflection of market expectations and diverging interest rate policy between two currency regimes.

2 Hedging from a Historical Perspective

3 Hedging Costs Outlook

Hedging costs are indeed a direct function of the difference between U.S. interest rates and the interest rates of foreign central banks, such as the ECB.

The total hedging expense, however, is also impacted by interest rate expectations.

5. Data provided by NCREIF. USAA REAL ESTATE – RESEARCH REPORT 3

Should foreign investors reconsider hedging U.S. real estate? The answer depends primarily on the investor’s risk tolerance. The previously mentioned INREV study suggests 29% of participants do not hedge currency risk from cross-border real estate. While it is difficult to know all the factors impacting this decision, the following highlights several points worth considering:

A Portfolio Strategy: An investor’s portfolio strategy can influence the level of currency hedging required. To start, investors should evaluate their exposure to U.S. real estate relative to their broader multi-asset portfolio. Furthermore, total return expectations are particularly critical in this environment, as opportunities further along the risk/return spectrum could be more attractive if they can absorb the drag caused by hedging costs and still deliver a solid return.

A Investment Horizon: A longer investment horizon provides flexibility. For example, a foreign investor may opt not to hedge if they do not immediately require the cash flow from real estate and can wait years, if necessary, until currency conditions are favorable to repatriate the capital to their home country. Conversely, if the cash flow is required to meet near-term liabilities, then hedging is likely essential given today’s currency volatility and diverging interest rate policy between the U.S. and many other central banks.

4 To Hedge or Not to Hedge

of participants do not hedge currency risk from cross-border real estate. 29%

4 THE RISING COST OF CURRENCY HEDGING – JULY 2018

A U.S. Dollar Outlook: An investor’s outlook regarding the Dollar can impact their decision to hedge currency risk. For instance, an investor may opt not to hedge if they believe the Dollar will continue to strengthen, relative to their home currency, during the period in which they hold their U.S. assets. In effect, not hedging is equivalent to taking a bullish position on the Dollar.

A Home Currency Volatility: Currencies within developed countries (e.g., EUR and GBP) tend to be more stable. Conversely, emerging markets tend to be more volatile, as is the case in much of South America, for example. Rapid currency fluctuations and large swings in value carry the potential for more currency risk. Therefore, a decision to hedge U.S. real estate can depend on the stability of an investor’s home currency as well. Consequently, market participants with a more volatile home currency are more likely to hedge investment risk.

A Mark-to-Market Implications: Mark-to-market is an accounting practice which requires investors to periodically record the value of an asset, reflecting its current market levels. While some countries may not adhere to this accounting practice, investors affected by this requirement may experience mark-to-market losses if they do not hedge currency risk, which could undoubtedly impact overall investment performance.

Ultimately, the decision to hedge currency risk associated with U.S. real estate is unique to each investor. With hedging costs becoming a substantial drag on returns, more investors may consider not hedging in the future. Conversely, opting not to hedge potentially exposes the investor to volatility in the currency market as highlighted in Exhibit 2. The question as to whether an investor should hedge currency risk does not have to be a binary decision either, as partial hedging may be suitable in some cases. In the end, an investor’s appetite for risk will ultimately govern the decision whether to hedge currency risk from U.S. real estate.

In effect, not hedging is equivalent to taking a bullish position on the Dollar.

Exhibit 2: Currency Volatility Impacts Returns 6

The Volatility of Real Estate & Currency Returns

15%

10%

5%

0%Sample portfolio 1

(sterling invested in Europe ex UK)

Sample portfolio 2 (US Dollars invested

in Europe)

Sample portfolio 3 (Euros invested in

the UK)

Sample portfolio 4 (US Dollars invested

in the UK)

Ann

ual c

hang

e

7.8%

10.0%

14.2%

9.4%

8.2%

10.5%

Volatility of real estate returnsVolatility of currency returns

9.4%

14.2%

6. Snapshot Research: The Impact of Currency on the Performance of European Non-Listed Real Estate Funds. February 2017, INREV, www.inrev.org.

USAA REAL ESTATE – RESEARCH REPORT 5

The Dollar has been volatile of late. Traditionally, as the Federal Reserve increases interest rates, it has the effect of reducing inflationary pressures while strengthening the Dollar. Despite a recent spike, the Dollar fell steady throughout 2017 (see Exhibit 3). This phenomenon is somewhat puzzling given the relatively optimistic economic outlook and the three rate hikes that occurred during the period. While the Dollar has recovered through much of 2018, market participants remain split on its long-term trajectory. The following highlights several critical factors that could influence the Dollar outlook going forward:

1. The global economy is improving which has the effect of normalizing an overpriced Dollar.

2. The Trump administration appears to prefer a weaker Dollar policy as a catalyst for stronger domestic exports.

3. The historically low interest-rate environment and the unwinding of quantitative easing have distorted traditional currency market assumptions.

Given today’s increased market uncertainty, hedging currency risk could be the prudent approach when considering U.S. real estate markets, unless foreign investors have a conviction regarding the direction of the Dollar.

5 Making Sense of the U.S. DollarExhibit 3: Trade Weighted U.S. Dollar Index

90

110

130

90

110

130

100

106

112

118

124

130

100

106

112

118

124

130

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130

125

120

115

110

105

100

2013-07 2014-01 2014-07 2015-01 2015-07 2016-01 2016-07 2017-01 2017-07 2018-01

Source: Board of Governors of the Federal Reserve Systemfred.stlouisfed.org.

6 THE RISING COST OF CURRENCY HEDGING – JULY 2018

While the Dollar has recovered through much of 2018, market

participants remain split on its long-term trajectory.

USAA REAL ESTATE – RESEARCH REPORT 7

Cross-border capital flows have played a critical role in the U.S. commercial real estate market during the current cycle. According to RCA, direct foreign capital acquisitions of U.S. real estate peaked in 2015 at just over $90 billion, nearly double the previous all-time high in 2007. Direct international purchases have since gradually receded from those recent highs yet still accounted for over 10% of all transactions in 2017. In the near term, however, U.S. investments may not be as attractive for foreign capital due to the drag on returns created by currency hedging costs. Core real estate could see a reduction in foreign capital demand, as the PREA Survey Forecast indicates NCREIF’s NPI index will deliver just 5.2% in 2018, which would be diminished considerably after accounting for hedging costs of potentially 200-300 basis points. Value-add and opportunistic investment may be more appealing to foreign investors given the potential for higher yields that can absorb the hedging drag and still deliver solid returns. Furthermore, core prices will likely soften given foreign capital sources have historically gravitated toward these assets.

6 Implications for U.S. Real Estate Markets

Exhibit 4: Health of U.S. Real Estate Markets Annual Foreign Capital Flows in the U.S.

100

90

80

70

60

50

40

30

20

10

02001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Tran

sact

ion

Volu

me

($B)

Source: Real Capital Analytics

8 THE RISING COST OF CURRENCY HEDGING – JULY 2018

In the end, foreign investors should consider multiple angles when deciding whether to hedge U.S. real estate currency risk. One perspective worth noting is that commercial real estate is just one of several Dollar-denominated assets that foreign investors will need to decide if or how to hedge, as the same issue is applicable across all major assets classes today. For instance, foreign investors into the U.S. face similar conditions regarding U.S. Treasury bonds, corporate bonds, high yield junk bonds, and the stock market. Indeed, there are variations in the fundamentals that drive returns in each asset class, but the effect on returns caused by fluctuations in the Dollar is generally the same.

Therefore, investors have to ask themselves: is U.S. commercial real estate still an attractive opportunity for foreign capital on a relative basis, given the current hedging costs? The answer, as noted previously, is unique to each investor. Some may choose to hedge (in whole or part), others may opt not to hedge at all, while some may find it impractical to invest in U.S. real estate right now. It is difficult to quantify the impact these conditions will have on the commercial real estate market, but ultimately, we think it could cause a decline in cross-border capital flows, softening in core prices, and a reduction in transaction volume. While risk management is a critical element in successfully managing a portfolio, the cost of mitigating currency risk may prove too expensive for some foreign investors who are considering investing in U.S. commercial real estate today.

Conclusion

It is difficult to quantify the impact these conditions will have on the commercial real estate market, but ultimately, we think it could cause a decline in cross-border capital, softening in core prices,

and a reduction in transaction volume.

USAA REAL ESTATE – RESEARCH REPORT 9

Will McIntosh, Ph.D Global Head of Research will.mcintosh@usrealco.com 210.641.8416

John Kirk, CAIA, CCIM Director, Research john.kirk@usrealco.com 210.690.6715

Mark Fitzgerald, CFA, CAIA Senior Director, Research mark.fitzgerald@usrealco.com 210.690.6706

Important DisclosuresThese materials represent the opinions and recommendations of the author(s) and are subject to change without notice. USAA Real Estate, its affiliates and personnel may

provide market commentary or advice that differs from the recommendations contained herein. Certain information has been obtained from sources and third parties. USAA

Real Estate does not guarantee the accuracy or completeness of these materials or accept liability for loss from their use. USAA Real Estate and its affiliates may make

investment decisions that are inconsistent with the recommendations or views expressed herein.

The opinions and recommendations herein do not take into account the individual circumstances or objectives of any investor and are not intended as recommendations of

particular investments or strategies to particular investors. No determination has been made regarding the suitability of any investments or strategies for particular investors.

Research team staff may make or participate in investment decisions that vary from these recommendations and views and may receive compensation based on the overall

performance of the USAA Real Estate or its affiliates or certain investment funds or products. USAA Real Estate and/or its affiliates or clients may be buying, selling, or

holding significant positions in investments referred to in this report.

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