Hedging foreign real estate exposure may protect underlying real estate characteristics and benefits

During my career, I have had many discussions on currency hedging strategies for real estate. Sometimes it was triggered due to high costs of hedging and other times these discussions were triggered by big swings in FX. Although there is not really a universal optimal strategy, I believe it is not too difficult to determine an effective strategy. 

Currency hedging strategies should be executed at the highest possible level, to centralise hedging and minimise costs and inefficiencies. Real estate US dollar exposures should be aggregated with all other USD exposures. It is, nevertheless, worth looking at the impact of currencies for each asset class individually. For instance, for fixed income it makes sense to fully hedge foreign currencies. The reason to have fixed income is the income and low risk. With currency effects, the risk would materially be impacted. As a result, it ruins the most important benefit of fixed income. For real estate the impact is shown in figure 1. The analysis is done for a European investor, holding 50% in European real estate, 50% in the US and hedging 90% of USD exposure.

Figure 1: Risk return profile of European and US direct real estate. The hedged portfolio is based on a 90% hedge. Source: Macrobond, Spek Advisory, data is unsmoothed and covers the period 1987-2022

As shown, US outperformed Europe historically, both on a hedged as well as on an unhedged basis. The unhedged portfolio is achieving a higher return compared to Europe, but also increases the risk. The hedged portfolio on the other hand, increases return and reduces risk. The important observation here is the material impact hedging has on risk. Not hedging would fundamentally shift the risk return profile, moving real estate more towards equity risk. Also, the Sharpe Ratio (using a 3% risk free) is higher for the hedged portfolio, which indicates that you would have achieved the highest return per unit of risk with the 90% hedged strategy. When looking at this from a US investor point of view, the results are very different, but the conclusion is the same (results can be shared on request).

Finally, it is interesting to see the impact of different levels of hedging. In figure 2, this is projected for direct, levered direct and public real estate.

Figure 2: Risk return profile for direct, levered direct and public real estate using different levels of hedging

It is obvious that hedging reduces the risk substantially, whether you are levered or not. Also when looking at the Sharpe Ratio, the highest ratios are achieved at either 90% or 100% hedged. Interestingly, hedging public real estate does not fundamentally impact the risk as it does for direct real estate. Based on the Sharpe ratio, a 20-30% hedging would be optimal. The volatility in public real estate is masking the volatility in currency, unlike in direct real estate. A similar conclusion can be drawn for other risky real estate strategies, like emerging markets where hedging is even complicated and expensive.

All things considered, to avoid a fundamental shift in risk and return profile, it makes sense to hedge a private real estate portfolio. 

If you want to know more about how best to hedge your real estate, infrastructure or private equity exposure, or if you are interested in other research and strategy topics, please contact us.