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The Risks of Investing in the Real Estate Markets of the Asian Region by Stephen L. Lee Department of Land Management, The University of Reading Whiteknights, Reading, RG6 6AW, England Phone: +44 (0) 118 931 6338, Fax: +44 (0) 118 931 8172 E-mail: S.L.Lee@reading.ac.uk Abstract The Asian region has become a focus of attention for investors in recent years. Due to the strong economic performance of the region, the higher expected returns in the area compared with Europe and the USA and the additional diversification benefits investment in the region would offer. Nonetheless many investors have doubts about the prudence of investing in such areas. In particular it may be felt that the expected returns offered in the countries of the Asian region are not sufficient to compensate investors for the increased risks of investing in such markets. These risks can be categorised into under four headings: investment risk, currency risk, political risk, and institutional risk. This paper analyses each of these risks in turn to see if they are sufficiently large to deter real estate investment in the region in general or in a particular country. Key words: Asian real estate markets, investment, currency, political, and institutional risks. Introduction Capital markets are becoming global markets and commercial real estate markets are no exception. Recently, international real estate investors have expressed interest in investing in the Asian emerging markets. Three main reasons can be given for investing in such markets. First the strong economic performance in the region, at least up to 1997 and the huge growth potential of the region in the future. For example over the period 1966-1991 the average annual real economic growth rate for Hong Kong, Japan, Singapore and Malaysia was greater than 6% while the comparable figures for the US and UK were between 2% and 3% (Greenwood, 1993). The second reason for investing in such countries is the very high returns such economic generates. Indeed in a survey of investors in the UK and Asia “higher returns” and the potential for “capital appreciation” were ranked one and two as the main reasons to hold foreign property, Lim (2000). A final reason apart from sharing in such economic growth and higher expected returns is the additional diversification benefits that may accrue. Studies have shown the considerable benefits to be gained from the international diversification in real estate markets (see Lizerli et al 1998 for a review). However, the economic convergence observed in world markets and the globalisation of the worlds financial system has led to the emergence of a number of key financial centres: London, New York and Tokyo, whose real estate markets are closely tied to the new international financial circuits. As a result their real estate markets are more integrated and so offer low diversification benefits, Lizieri (1992). Thus the benefits for portfolio risk reduction are likely to be even greater from diversify into emerging markets, Divecha et al (1992). Consequently countries in the Southeast Asian region including: China, Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand have come to be seen as areas of future investment because of their huge growth potential, greater returns and portfolio diversification benefits. Despite all of this most institutional investors still display a reluctance to go overseas in general and into emerging markets in particular, Solnik (1974). One explanation for such a reticence is the possibility that investors impute “extra” risk to foreign investments, French and Poterba (1991). In other words international investment may also increase an investor’s exposure to other pervasive economic factors, and therefore increase the investor’s level of risk. These risks include an increased exchange rate risk, greater exposure to political risk, and greater tax uncertainty, thus increasing the risk of overseas investors relative to domestic investors. Consequently the lack of investment in the emerging markets of the Asian region may simply be a perception that the returns achieved in such markets is not sufficient given the risks. The emerging real estate markets of the Asian region therefore need to be evaluate to see whether the assumption that the expected returns in the emerging markets of the Asian region are not adequate to cover the increased risks borne by the foreign investor. In analysing overseas investment in general and emerging markets in particular two broad areas of enquiry have developed. The first area of interest relates is their inherent volatility and the second the informational efficiency of the markets. For example emerging markets can be characterised by their skewed wealth distributions, small size and concentrated market structures all of which it can be argued accentuates return volatility, Divecha et al (1992). Thus it may be felt that there is a greater investment risk from emerging markets than from investment in developed countries. In addition the greater political instability and higher levels of inflation in such markets is likely to lead to greater fluctuations in exchange rates making these locally volatile returns even more volatile when converted to the foreign investors home currency. On the question of informational efficiency emerging markets by their nature have more recent origins than developed markets in addition to which they have adopted differing policies relating to the financial and real estate sectors than developed countries. Hence it can be argued that emerging markets differ from their counterparts in the developed world in terms of their institutional structures and informational related attributes. Which can be characterised in terms of tax treatment of locals versus foreign investors, regulations of market entry and exit and factors relating to the quality and quantity of information dissemination. In particular any differential in the tax treatment of local and foreign investors and any impediments that are placed on foreign investors from entering the market and/or hinders repatriation of income and capital inhibits participation by foreign investors so limiting market liquidity and increasing volatility. Finally the free flow of information to all investors is a necessary condition for market pricing efficiency, without which mispricing can take place. The newness of emerging markets and the different institutional structures adopted, compared with developed countries, suggests that access to all relevant information by all investors, especially foreign investors, is unlikely to be the case. All of which suggests that unless an outsider is fully aware of the institutional structures of the market, both formal and informal, they are likely to be at a major disadvantage compared with local market players, Guerts and Jaffe (1996). This institutional risk depends on the maturity and transparency of the market (Gordon, 1999 and Keogh and D'Arcy, 1994). Thus if investors can become more informed of the institutional structures and business practices of overseas markets they are more likely to invest in those markets, i.e. “familiarity breeds investment”, Stratman (1999). Consequently from the discussion above the risks facing a foreign real estate investor can be broken down into four categories: investment risk (the volatility of returns), currency risk (exchange rate volatility), political risk (explicit barriers to capital flows, taxes, expropriation, and exchange controls) and institutional risk (market maturity, size and liquidity, regulation, and information). Each of these is analysed in turn to see if they are sufficiently large to deter investment into the emerging markets of the Asian region. Investment Risk In the equity and bond markets there is abundant literature on the benefits of international diversification. Madura (1985) provides an excellent review of the work as of 1985, while Lonie et al. (1993) extends the coverage to 1993. All studies concluding that the risk and return advantages of international diversification are very large for investors in all the major countries. Indeed with more assets to choose from a more widely diversified international portfolio cannot do worse than a one based on domestic stocks only. In contrast the issue of international real estate diversification has received scant attention in the academic literature (Eichholtz et al, 1996). In general data limitations have resulted in less research being undertaken. As it is felt that investment in merging markets is more risky than investment in developed markets it could be argued that this alone will deter investors. Indeed Lim (2000) finds that UK investors are much more risk averse than their Asian counterparts. Consequently the greater perceived risk of investing in the countries of Southeast Asia would seem to be the main reason for avoiding the area. This perception can be questioned on at least two counts. First, modern portfolio theory (MPT) tells us that investors should focus on the expected return and risk of their portfolio as a whole rather than on the return and risk of each asset in isolation. In other words individual risks are not of consequence because they can be diversified away at the portfolio level. Indeed although the issue of international real estate diversification has received limited attention in the academic literature (Eichholtz et. al, 1996) even though the globalisation of financial markets has a particular significance for international property investment. The few studies that have examined clearly show that the risk and return advantages of international diversification are very large for investors (see Lizieri et al, 1998 and D’Arcy and Lee, 1997). The research undertaken in securitised property markets has generally tended to support the benefits of risk reduction through an international real estate portfolio (Giliberto, 1990, Asabere et al, 1991, Eichholtz and Lie, 1995 and Case, et al, 1997). These results are confirmed when using data from the direct property market (Del Casino, 1986, Sweeney, 1989, Gordon, 1991, Wurtzebach, 1991 and D’Arcy and Lee 1998). Furthermore, the one study that that has examined the benefits of including the emerging markets in a global portfolio, albeit with securitised property data, finds that including at least some investment in emerging markets would have reduced the risks associated with developed country portfolios. While Eichholtz et al (1996) finds that the existence of continental factors in determining property market returns means that emerging markets are a source of diversification benefit to both American and European investors. Secondly, the tendency to lump emerging markets as a homogeneous group is a mistake. The work by Eichholtz and Lie (1995) Eichholtz et al (1998a) on securitised property shows that additional diversification benefits accrue to investors within the region. Indeed the following data on the direct property market confirms this view. In order to investigate the risk/return performance from investing in the Asia-Pacific region in comparison with markets in the US and Europe the annual total returns from investing in the Office market of the capital (main) cities of the UK, USA, Europe and Asia-Pacific region over the period 1985-1997 were extracted from the ONCOR database. The appreciation figures, however, are not based on appraisals, but upon changes in capitalised asking rents. The use of asking rents may make it difficult to identify sharp declines in commercial real estate markets, since effective rents typically lead asking rents in declining markets. The rental figures used are net of service charges and local taxes. In calculating returns no adjustment was made for exchange rates between countries. The rational for not expressing returns in a common currency is to segregate the local market risk from currency risk for a number of reasons. First it is well known that these two risks are not additive and that expressing the various local market portfolio returns in a common currency will have an adverse impact on their conditional mean and volatility measures. Second the correlation coefficient between a set of local market portfolios is typically smaller when a currency factor is added in their returns. Studies, therefore, which use common currencies, have great difficulty in dissociating these two risks. Thus caution is needed to interpret the results of such an analysis, if based in a common currency, as the result of such studies can be misleading, Engle and Susmel (1993). Therefore the case for investment in the Asia-Pacific region needs to be examined in isolation from exchange rate movements. Table 1: The Risks and Returns of Investing in the UK, USA, Europe and Asian Emerging Markets 1985-1997 UK USA European Core Belgium Denmark France Germany Holland Asia-Pacific Australia Hong Kong Malaysia Singapore Taiwan Average European Core Asia-Pacific Average Averag e % 10.52 2.18 SD Correlation % 22.99 8.19 UK 1.000 0.076 USA 0.076 1.000 13.12 4.14 9.42 8.37 9.43 14.45 14.68 18.68 13.87 10.84 0.368 0.121 0.431 0.147 0.286 0.190 -0.502 0.329 -0.343 0.062 15.34 38.26 22.99 26.06 40.06 23.26 34.35 53.14 45.29 54.78 0.754 0.383 -0.364 -0.134 0.138 0.079 -0.380 -0.294 -0.066 0.001 8.89 28.54 14.51 42.17 0.271 0.156 -0.053 -0.132 Source: ONCOR Table 1 shows that an institutional investor in the UK and especially the ones in the USA would have achieved much higher returns from investing in the emerging markets of Europe and Asia-Pacific. Indeed surveys show that increased expected returns is the main motivation for investment in Southeast Asia, Lim (2000). Naturally such an increased return would also be accompanied by increased risk (standard deviation) on an individual country basis. However, Table 1 also shows that the correlation between the UK and the US with the emerging markets of Asia was on average much lower than that with Europe. In addition the average intra-regional correlation within Europe was 0.236, and that within Asia 0.169. In other words the Asia-Pacific region not only offers greater returns to UK and US investors but shows greater intra-regional diversification benefits than Europe. This evidence on the benefits of international investment into emerging markets once more lends support to the arguments in favour of international diversification: lower portfolio risk arising from low correlation across countries and higher returns arising from faster-growing economies. However even this strong case for international diversification into emerging markets seems to be insufficient to convince investors to invest in these markets. Thus the lack of investment must be the related to the addition risks investors perceive as important when investing overseas. Currency Risk Investment overseas is a “two edged sword”. In that while investors may reap the benefits of increased returns at lower portfolio risk when they venture overseas, such investors suddenly find themselves exposed to a relatively new type of risk, currency risk. Consequently Madura (1992) indicates that because overseas investors are more affected by exchange rate variations relative to domestic investors, they may have riskier returns. While Eun and Resnick (1988) note, fluctuating exchange rates may mitigate the gains from diversification. Thus what is the impact of currency exposure on investment returns? What is Currency Risk? As explained in Eun and Resnick (1988) the domestic market return Rid, from an unhedged investment in the ith foreign market is given by (1 + R id ) = (1 + R i )(1 + e i ) (1) R id = R i + e i + R i e i (2) Which can be written as: Where Ri is the return of property in the local foreign currency and ei is the rate of appreciation (depreciation) of the local currency against the domestic investors currency. The last term of this equation will generally be smaller than the first two, since it equals their product, and both are generally less than one. Thus equation (2) can be restated as an approximation: R id = R i + e i (3) It can now be seen that the return on a foreign investment (Rid) can be decomposed into two parts representing the local market return of the investment (Ri) in the ith country and the return on the foreign exchange rate (ei). Thus if ei is negative and greater than Ri the home base return will be negative! In contrast if ei is positive and greater than the local foreignbased asset returns, which could be negative, the investors home based returns can be positive! In other words the rate of return faced by an investor from a foreign-based investment can be significantly increased (decreased) by the appreciation (depreciation) of the foreign countries exchange rate compared with the investors domestic currency. By the same reasoning the risk (standard deviation) of the foreign currency based investment returns is given by: σ id = σ 2i + σ2e + 2σ i σ eρ i ,e (4) where: σi is the individual risk of the property investment in the ith country, σe is standard deviation of the ith countries exchange rate relation to the investors home base currency and ρie is the correlation of the ith countries property returns with the exchange rate. Thus equation (4) reveals that the smaller the correlation between the returns on a foreign currency and the returns on a foreign investment, the smaller will be the foreign investment risk. Indeed if ρie is negative an investor who ventures overseas could be holding an investment in a ‘risky’ foreign country that displays little or no risk when converted back into his home base currency. Consequently the impact of currency risk can be easily exaggerated. Indeed currency returns can offer enhanced foreign market returns as equally eliminate them. In other words exchange rate adjusted returns are equally likely to be increased as well as reduced by the impact of exchange rate changes. While the increased risk faced by investors in foreign country assets need be only marginally greater than that of the local country returns, so long as the correlation between the local foreign market returns and the exchange rate is low or even negative. Furthermore investors have at their disposal a number of money market instruments with which they can hedge currency fluctuations. However, given the long term holding periods of real estate investment and the cost of hedging using traditional methods the difficulties of applying hedging techniques are problematical, see Worzala (1995), Worzala, et al (1997), Worzala and Newell (1997) and Lizieri, et al (1998) for reviews. Should Investors Hedge Currency Risk? Gastineau (1995) argues that given the success of currency derivative funds and overlay managers there are apparently possibilities to add value through active currency management. According currency management could be a source of portfolio risk reduction and/or return enhancement. Indeed Perold and Shulman (1988) show that based on theoretical assumptions, hedging currencies can generate non-zero returns, especially in the short run. The authors then show that not only does investing internationally leads to risk reduction; fully hedging currency exposure leads to additional risk reduction while maintaining the return profile. In other words investors are faced with a “free lunch” from hedging currency risk. From their perspective, this is the main attractiveness for hedging currency exposure. In contrast Froot (1993) argues that long-term exposure to currency movements, for example by employing forward rate agreements, generate zero returns. Using 200 years of data Froot finds that in the short run, following the work done by Perold and Shulman, hedging (fully) reduces volatility. However, if the holding period of an Equities portfolio exceeds five years, a fully hedged portfolio exhibits a larger volatility than an unhedged portfolio. In the case of a Bond portfolio the crossover point is on average eight years. In other words (partially) hedging currency exposure is a waste of transaction, management, administrative and opportunity costs. Given that investors often see Real Estate investment as a hybrid Equity/Bond security this would suggest that the cross over point of property investment is about six years. In other words if investors holding period is about six years currency hedging is not only of little use but actually detrimental. Froot attributes this result to the tendency that exchange rates exhibit mean reversion characteristics due to the equilibrating force of Purchasing Power Parity (PPP). Thus if exchange rates mean revert they can have no added value to the risk profiles of the portfolios of long term investors. However, in a floating exchange rate regime, where PPP does not hold perfectly, an overseas investor faces exchange rate risk (Solnik, 1974). Nonetheless Froot concludes that in the long run exchange rates are more or less stable. Consequently the minimumvariance hedge (using derivatives) cannot reduce volatility below that of an unhedged portfolio over long run investment horizons. Furthermore Gardner and Stone (1995) and Jorian (1985) both argue that the input estimates used to come to an optimal hedge ratio strategy will result in substantial estimation errors. Thus if investors have a low to moderate risk tolerance, the use of the hedge ratio probably won't have any meaningful added value. In contrast Filatov and Rappoport (1992) in a study on international bond investing covering the period 1980-1989 have shown that a fully hedged position on the part of British, Japanese and German investors would have lead to additional risk in the portfolio. However, the period involved, the base currency and the fact that these premiums are nonstationary can explain these results. Indeed within the real estate market the work of Ziobrowski and Ziobrowski (1993), Addae-Dapaah and Choo (1996) and Worzala (1995), all find that although currency derivatives provided a limit to the magnitude of downside losses over relatively short periods (one year), their effectiveness was lost over the typically longer holding periods of real estate investment. Moreover the periodic costs of hedging easy offset the gains. Thus when short-term volatility is not an issue for an investor, they should not hedge currencies as this will only result in increased costs and therefore reduce the return potential of an investment portfolio. Nonetheless Perold and Shulman (1988) argue that the performance of international investors should be measured in local currencies (fully hedged) and every decision to have a different exposure than the base currency is an active investment decision. In other words currency decisions can affect performance and so should be accounted for in assessing the success of fund managers investment decisions. Indeed this argument is adopted in performance presentation standards by AIMR, the US financial analyst organisation. Thus if fund managers deviate from the standard they have to inform investors as to the benchmarks they are using. This implies investors are aware of the importance of currency risk can have on the overall risk of a portfolio and so it needs to be accounted for in evaluating the fund’s overall performance. However, the perceived importance of currency risk to institutional real estate investors is not uniform. For example, Worzala (1994) reports that only 44% of the UK, Dutch and German institutions sampled perceived currency fluctuations as an important variable in the international investment decision. Although this may be due to the preference of European investors to concentrate their overseas investments in the other countries of Europe or the developed markets such as the US and Australia, where currency risk may be felt to be of only a minor impact. Similarly McAllister (1999) finds that British institutions rank currency risk fourth in a possible list of eight potential problems associated with overseas investment. In contrast similar surveys based on Asian investors found that the respondents are much more concerned with exchange rate risk than investors in Europe, Worzala and Newell (1997) and Lim (2000). In other words although currency fluctuations are not perceived as the primary concern of investors when considering international diversification (except by Asian investors), it appears to play a minor role. Even in the Asian market the actual impact of currency risk is apparently small and insignificant. Addae-Dapaah, and Yong (1998) in a study of currency risk on office investment within the Asian region find that for a single country investment. exchange rate risk can be substantial. Nonetheless the impact was statistically insignificant, consistent with the findings of Ratcliffe (1994), Ziobrowski and Curico (1991) and Worzala (1995). In other words when the impact of currency risk is considered in a portfolio context the authors found that the potential diversification benefits from international investment outweigh the supposed ravages of currency risk. Thus an investor with a fully diversified portfolio should not be overly concerned with currency risk. Supporting the conclusions of Solnik (1996) that exchange rate risks have never been a major component in a diversified portfolio over a long period of time. Indeed Sweeney (1989) considers the additional risk of exchange rates to real estate investment to be minimal. Whist Solnik and Odier (1993) and Drummen and Zimmermann (1992) find that the currency risks are only a minor determinant of European stock return variances. Thus a review of the academic work on the question as to whether investors should hedge or not their currency exposure shows that a simple solution is not obvious. Should Currency Risk Play a Role in the Investment Decision? However, is currency risk management the function of the real estate fund manager? In other words is the allocation decision to invest in certain countries an integrated or a separated process incorporating both the asset and currency implications of international investment? The answer to this question highlights a difference between practice and academia. To the academic international investment is usually viewed as an integrated process. Where the decision as to what assets to hold is entwined with the currency implications of such decisions. In contrast practitioners look upon country allocation and the embedded exposure to currency movements from a separated perspective. For example, many multinational firms use a currency overlay approach when considering their investment overseas, Meijer (1996). In other words foreign currency exposure is treated as a separate asset from the actual invest and is managed by a separate specialist team (Giddy, 1994). In summary, movements in foreign exchange rates occur so as to achieve equilibrium position between countries in terms of inflation and interest rate differentials, and as a results create a neutral effect on investment in the long run. Unfortunately it seems that currencies can have a substantial impact on real estate investment returns, in the short and medium term, making the management of exchange rate during these periods vital to the immediate future heath of the investor. However, currency risks can be overstated, for a number of reasons. First, for long term investors there is a zero correlation between real estate returns and exchange rates in nominal terms means that foreign investors are not necessarily at greater risk than domestic investors. Secondly, long tem investors are more concerned with the real rather than nominal returns from their investments. The resulting inflation adjustment will reduce the impact of exchange risk, given the purchasing power parity (PPP) relationship. In other words PPP neutralises exchange risk for long-term investors. Thirdly, currency risk can be hedged through a number of money market instruments. Fourth, real estate typically represents a minor proportion of the mixed-asset portfolio to long term investors, insurance companies and pension funds, the impact of exchange rate risk on the