Can you price geopolitical risks?

Economic and political pressures are contributing to a drop in commercial real estate investment volumes. But underwriting macro-uncertainty is more art than science.

Tensions are on the rise in Hong Kong as tens of thousands of demonstrators took to the streets this week to protest against lawmakers intending to pass a bill allowing extraditions to China.

The clashes are the latest among a multitude of geopolitical headwinds causing financial market anxiety, including China’s deepening trade war with the US. Christine Lagarde, managing director of the International Monetary Fund, said last week that it could cost a dizzying $455 billion in lost output in 2020. The cocktail of risks also includes Brexit, an economic slowdown in the US, various country rate hikes and a bevy of elections, such as those in the European Union, India and Australia.

Unsurprisingly, these issues have taken a toll on the real estate industry. On Wednesday, real estate stocks in Hong Kong’s benchmark Hang Seng index fell by 1.7 percent. More broadly, according to Real Capital Analytics, global commercial real estate transaction volumes stood at $310.3 billion in Q1 2019, a 23 percent year-on-year drop.

Macro uncertainty is today’s reality. But how are managers pricing this uncertainty while making investment decisions? Here are a few metrics to consider while underwriting political and economic risks, based on PERE’s conversations with industry stakeholders:

Choice of strategy: Managers raising capital for funds appear to be less perturbed, partially because of the unpredictability surrounding when some of these risks will dissipate. One London-based manager running several open-end core funds said he looks through economic cycles and short-term geopolitical risks. In his view, he can sit on the sidelines for three years, waiting for the worst phase of the US-China trade war to pass, but investors will not thank him for not investing, so China continues to be an investment target.

Meanwhile, if you are an opportunistic fund investor, market distress can yield more opportunities. One asset manager believes the UK has in fact become “relatively cheap compared with some European markets” amid the Brexit logjam, with the London office sector currently offering an extra yield of 100-150 basis points.

Choice of sector: When it comes to deployment, however, managers are staying away from volatile assets or portfolios affected by short-term economic swings and are choosing more defensive investments benefiting from urbanization and demographic trends. An Asian manager currently in market with an opportunistic fund told PERE the firm is avoiding investing in office assets with multinational tenants in China and instead opting for assets in the educational and medical sectors. In case of logistics, the preference is for warehouses with tenants whose businesses depend on local consumption instead of bonded warehouses relying on exports and imports.

Choice of hedging policy: Whether to invest in the US or UK also hinges on how much hedging costs investors can take on. The dollar-yen and the dollar-won exchange rates have not been favorable toward Japanese and Korean investors. One South Korean life insurer told a local Korean news website that its current hedging losses, while investing in the US, are 17.5 won per US dollar.

Meanwhile, for a yen investor, hedging US investments eat up almost 2.8-3 percent of the returns. As a result, more of these investors are preferring to invest in Europe. For instance, South Korea’s Hana Financial Group spoke with PERE in March about its interest in European core and core-plus assets like logistics and data centers.

It is hard to make a science of political underwriting – artistry is certainly a feature in this regard. Investors have long demanded a risk premium for investing in developing and emerging countries, so some element of country risk usually naturally gets priced in. But many macro risks today involve developed, mature economies, which provide little to no risk premium to cross-border investors. And that takes underwriting to another place entirely.


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