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Important information

I confirm that I am accessing this website for the purpose of acquiring information as, or for, an Institutional Investor (a corporate or other non-retail investor acting for their own account).

I understand the information contained in this website is not directed at, nor is it intended for distribution to, or use by, persons in any jurisdiction in which the dissemination of such investment related information is not permitted. I also understand that the information contained in this site is not directed to any party that may be defined as a ‘retail investor’ by the home regulator of the country in which the website is being accessed. I understand that the information or opinions contained herein should not be construed as an offer to sell or the solicitation of an offer to buy any investment product nor shall any such investment products or services be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful. Fidelity has expressed its own views and opinions on this website, and these may change and there is no obligation to update them. Nothing in this website should be construed as investment, tax, legal or other advice. The information contained herein is subject to change without notice.

This website has been issued by FIL Fund Management Limited, a Bermuda company licensed to conduct investment business by the Bermuda Monetary Authority. Neither FIL Fund Management Limited, its parent company FIL Limited, nor any of their group companies or affiliates makes or gives any warranty or representation that any information contained on this website is accurate, complete, or fit for any particular purpose.

I acknowledge that neither FIL Fund Management Limited, FIL Limited, nor any of their group companies or affiliates will have any liability for any losses arising directly or indirectly from any information accessed from this website. By accepting this representation I also confirm my agreement to the website Terms and Conditions, which I have read and understood.

Please note that FIL Fund Management Limited is not licensed by the Liechtenstein Financial Market Authority (“FMA”) and is not subject to the supervision of the FMA.

Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited, a company existing under the laws of Bermuda.

If the above representation is correct, please click 'I agree' below to continue to the site.

Wichtige Informationen

Hiermit bestätige ich, dass ich diese Website zur Informationsbeschaffung als institutioneller Anleger (ein auf eigene Rechnung handelndes Unternehmen oder ein anderer nicht als Privatanleger geltender Investor) bzw. für einen institutionellen Anleger besuche.

Mir ist bewusst, dass sich die Informationen auf dieser Website nicht an Personen richten bzw. für sie bestimmt sind, in deren Land die Verbreitung solcher anlagebezogenen Informationen nicht erlaubt ist. Mir ist ebenfalls bewusst, dass sich die Informationen auf dieser Website nicht an Adressaten richtet, die von der Aufsichtsbehörde in dem Land, von dem aus die Website besucht wird, möglicherweise als „Privatanleger“ klassifiziert werden. Des Weiteren ist mir bewusst, dass die hier zu findenden Informationen oder Meinungen nicht als Aufforderung zum Kauf oder Verkauf eines Anlageprodukts zu verstehen sind. Es sollen auch keine solchen Anlageprodukte oder Dienstleistungen Personen angeboten oder verkauft werden, in deren Land ein entsprechendes Angebot, eine Aufforderung, ein Erwerb oder Verkauf ungesetzlich wäre. Fidelity äußert auf dieser Website seine eigenen Ansichten und Meinungen, die sich jederzeit ändern können, ohne dass eine Verpflichtung zur Aktualisierung besteht. Kein Inhalt dieser Website ist als Beratung in Bezug auf Geldanlagen, Steuern, rechtliche oder sonstige Aspekte zu verstehen. Die hierin enthaltenen Informationen können sich ohne entsprechende Mitteilung jederzeit ändern.

Diese Website wurde von FIL Fund Management Limited eingerichtet, einem Unternehmen mit Sitz auf bzw. nach dem Recht der Bermuda-Inseln, das über eine Genehmigung der Bermuda Monetary Authority zur Ausübung von Investmenttätigkeiten verfügt. Weder FIL Fund Management Limited noch sein Mutterunternehmen FIL Limited oder irgendein anderes Konzernunternehmen oder verbundenes Unternehmen übernimmt die Gewähr dafür oder erklärt, dass die Informationen auf dieser Website zutreffend, vollständig oder für jedwede Zwecke geeignet sind.

Ich erkenne an, dass weder FIL Fund Management Limited noch FIL Limited oder ein anderes Konzernunternehmen bzw. verbundenes Unternehmen für etwaige Verluste haftet, die direkt oder indirekt aus einer auf dieser Website beschafften Information resultieren. Durch Annahme dieser Erklärung bestätige ich auch mein Einverständnis mit den Nutzungs- und Geschäftsbedingungen dieser Website, die ich gelesen und verstanden habe.

Fidelity International, das Fidelity International Logo und das F-Symbol sind Markenzeichen von FIL Limited, einem nach dem Recht der Bermuda-Inseln eingetragenen Unternehmen.

Bitte beachten Sie, dass die FIL Fund Management Limited von der Finanzmarktaufsicht Liechtenstein weder zugelassen noch beaufsichtigt ist.

Diese Website präsentiert Informationen in englischer und deutscher Sprache. Als professioneller Anleger akzeptiere ich hiermit, Informationen in mehr als einer Sprache zu erhalten.

Wenn die obige Erklärung zutrifft, klicken Sie bitte auf „Ich stimme zu“, um auf die Website zu gelangen.

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Currency risk in pan-European real estate

by Kim Politzer Director of Research, European Equity

Published 10 July 2019

CurrencyReal EstateEurope

Currency volatility has the potential to wipe out the returns of pan-European funds, even those with a small percentage of non-euro denominated assets. Attempting to diversify currency risk away can actually increase volatility, while hedging is often imperfect and increases costs. The best solution might be the simplest: avoid mixing currencies unless the underlying investment is exceptional.

Currency and pan-European real estate funds

Funds in the MSCI Pan-European Property Funds Index (PEPFI) report their net asset value (NAV) in euros, although a meaningful proportion of the properties held within these funds are not located in the Eurozone and not priced in euros (Chart 1).

Note: Other includes, Czech Republic, Poland, Hungary and Denmark. Real estate in these markets is less exposed to currency risk as assets and cash flows are priced in euros, or currency is tightly pegged to the euro. Source: MSCI PEPFI, Q4 2018.

The biggest currency exposure is to the UK market, which accounted for around 12 per cent of the PEPFI at the end of 2018, and there is also a sizable exposure to the Swedish market. In addition, although Central and Eastern Europe (CEE) assets and income streams are priced in euros, there is still risk, albeit limited, that if currency volatility increases sharply, the income stream and the assets themselves may be re-priced into local currency. 

The best example of this is Russia. After the devaluation of the ruble following the financial crisis, tenants found lease obligations priced in dollars. increasingly difficult to meet from their local currency-denominated income. Market pressure forced landlords to convert leases to local currency and it is now market convention for assets to be priced in rubles too.

Chart 2 illustrates the additional volatility that currencies add to European real estate returns. Over the past 10 years, the volatility of returns from property in France and Germany is around 2 per cent when priced in euros, but jumps to over 10 per cent for investors using US, Canadian or Australian dollars.

Chart 2:  Currency adds volatility to real estate returns in key Eurpoean markets for investors outside the Eurozone

Currency

USD

USD

AUS

AUS

CAD

CAD

EUR

EUR

 

Return

Volatility

Return

Volatility

 Return

Volatility

Return

Volatility

France

5.3%

11.8%

11.4%

10.0%

5.5%

10.0%

7.3%

1.6%

Germany

5.3%

12.8%

11.5%

10.2%

5.2%

10.3%

7.3%

2.2%

Sweden

5.9%

12.3%

12.0%

11.1%

9.1%

9.4%

7.9%

6.3%

UK

7.0%

12.4%

13.3%

16.7%

8.8%

12.6%

9.1%

14.0%

Return is average annual return 2009 - 2018, volatility is standard deviation of these returns. Source: Fidelity International, MSCI European Indices, 2018.

To assess the potential impact of currency on the PEPFI specifically, we estimated the local currency asset level returns based on the composition of the index each year, and compared this with the published euro-denominated returns. Chart 3 clearly shows that even though the PEPFI as a whole has a relatively modest exposure to currencies other than the euro, that exposure increases the volatility of returns when compared to the returns in local currency.

Source: Fidelity International, MSCI European Indices, 2018.

While euro-based returns over 10 years have been higher thanks to favourable currency movements, risk-adjusted returns have been lower due to the added currency volatility. This is despite less than 15 per cent of the assets in the index being denominated in non-euro currencies. This has led to significant differences in returns in some years (over 900 basis points in 2008, almost 500 basis points in 2014 and 2015). And given the illiquid nature of the asset class, this could have a devastating impact, depending on the timing of investment or disinvestment.

Approaches to managing currency risk

A Managing Currency Risk in International Real Estate Investment, Investment Property Forum, April 2018. found that while there was a wide range of approaches being used to manage currency risk, clients and managers generally did not have a good understanding of that process.

Managers have several options to manage the risk, or can use local leverage to reduce currency exposure. However these approaches increase costs. Furthermore, the best instruments for hedging currency risk vary depending on market conditions. Given the current uncertainty relating to the persistence of late-cycle market conditions, choosing the optimal strategy is not straightforward. 

Other managers may take the view that currency risk can be diversified away, or that currency is neutral over a long holding period. However, there is evidence that the intervention of central banks after the global financial crisis has broken down interest rate parity relationships. Hence the assumption of long-run currency neutrality may no longer be valid.  

Some investors prefer to manage currency risk themselves as part of a broader currency management strategy across all asset classes. But with pan-European real estate fund units priced in euros, this is difficult for investors to achieve fully. 

Finally, the characteristics of real estate investment, including its illiquidity and the ability to drive performance through active asset management can make management of currency exposure even more difficult. It is not possible to reshape a real estate portfolio quickly in response to changes in currency markets. And where hedging is in place, changes to the valuation or the expected cashflow of a property can conflict with the currency strategy. Rather than creating diversification, multiple currency exposures could increase exposure to loss and embed volatility in a portfolio.

Why this matters now - heightened currency risk

There are reasons why currency may have a greater impact on performance in the next few years than it has historically.

In the short term, political uncertainty looks set to increase currency volatility. For example, the implied volatility of sterling against the dollar jumped in November 2018 and drifted up as the first Brexit deadline approached (Chart 4). Higher volatility usually indicates a heightened expectation that uncertainty will jolt a currency. In the case of the UK this appears to reflect a lack of consensus about the form that Brexit will take and the implications that this has on Sterling. 

Source: Refinitiv, April 2019.

The UK’s departure from the European Exchange Rate Mechanism (ERM) provides an historical example of a major domestic crisis (Chart 5). After an immediate fall of 30 per cent against the dollar, Sterling spent the next 12 months at an average discount of 15 per cent compared to the previous year. This could be seen as a benchmark in the case of a ‘no deal’ Brexit

Source: Refinitiv, May 2019.

Other factors that may result in more currency risk during 2019 and 2020 include:

  • Political developments such as rising populism, social unrest, and trade wars; 
  • Divergence in monetary policy as quantitative easing (QE) is unwound at differing rates across the globe. This contrasts with the long period of interest rate policy similarity following the global financial crisis. The risk of policy missteps in unwinding QE creates uncertainty and may also result in prolonged periods of currency strength or weakness that are not necessarily consistent with relative interest rates. This environment of unprecedented monetary policy makes the suitability and cost-effectiveness of hedging over a medium-to-long-term investment horizon typical of real estate difficult to assess; 
  • Lack of consensus over how the current ‘late’ phase of the economic cycle may play out in major economies over the next two to three years.

These issues are contributing to rising hedging costs, which in turn are beginning to influence global capital allocation. At present this is most clearly demonstrated by the reduction of capital flows from Asia into US real estate. As interest rates have diverged, hedging costs have risen, causing some investors from the region to look elsewhere. This has also been an issue for euro-denominated investors. Chart 6 illustrates how diverging interest rates have had a significant impact on USD:EUR hedging costs.

Source: Refinitiv, May 2019.

As Chart 6 shows, hedging costs can exceed 200 basis points, which can be the difference between making an investment viable or not.

Conclusion

The impact of currency exposure on European real estate portfolios is not always understood and can be underestimated. As an example, data from MSCI suggest that even though currency risk in the PEPFI is concentrated in two markets and accounts for less than 20 per cent of the weight, it increased volatility by more than 50 per cent over the past 10 years. 

Because of the nature of real estate investment, a portfolio with multiple currency exposures has the capacity to increase exposure to loss and volatility rather than provide diversification. While it is possible to hedge currency risk, this comes at a cost that can be sizeable. Hedging also has the potential to embed losses and volatility within a portfolio.

Uncertainty around the future path of interest rates is high and currency volatility could increase as extraordinary monetary policy is unwound. It is therefore important for investors to be aware of the range of currency risks that they may be exposed to within pan-European funds, how these risks are being managed, and the cost of managing this exposure.

In an illiquid asset class like property, where investment horizons are long but initial investments (and indeed disinvestments at a later date) are locked in during a particular year, currency risk can introduce very significant and unintended risks, potentially wiping out gains from the underlying property investment itself. The answer may be an easy one: don’t ‘pollute’ your property portfolio with exposure to multiple currencies unless you really have to, or unless the investments are truly exceptional.

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