Country risk is the risk that cross-border cash flows will not be realized because of disequilibrium between the domestic platform and that of another country. Given this potential concern, one may require higher returns from an investment as an offsetting factor. Factors that influence country risk can be partitioned a number of ways. We use a simple, two-factor approach:
Political risk. Political risk is concerned with government structure, policy, leadership and stability, conflicts, tensions and war, politican parties and bureaucracy. A measurement of political risk would attempt to capture the degree of movement along the continuum of political freedoms that lead to stable environments over time. Much of the research to date has tended to use qualitative factors in such measurement.
Economic risk. Economic risk is concerned with the stability of exchange rates and the performance of the economy. The measurement of economic risk is more quantitative, and insight can be obtained from factors such as output growth, inflation, debt, current account balances and exchange rates. Focusing more directly on business and real estate transactions, factors to be considered include contract law and enforcement, the nature of property rights, the ability to meet financial obligations, bankruptcy laws and methords for handling defaults.
The various dimensions of political and economic risk are interactive and interconnected. Consequently, we explore only a few of the many factors that influence country risk and try to gain some insight as to the level of risk currently present in the global arena. The factors considered are presented below. The division of the countries by income status is based on the World Bank classification of economies.
The single best indicator of the level of country risk is the level of income received by each citizen. As per-capita income levels increase, the pressures for political change are likely to be reduced and economies flourish, producing a decline in country risk for the cross-border investor. The per capita income measurement is adjusted for purchasing power parity (PPP), providing a more realistic measure of differences in the standard of living by country.
The absolute level of GDP is also an indicator of reduced country risk, even after adjusting for the factor of high per-capita income. In general, larger economies are less risky economies. As economies expand, the level of country risk usually declines. Sound monetary policy, resulting in low levels of inflation, is also a feature of countries with a lower level of country risk. By contrast, rapidly expanding money supplies and persistent high levels of inflation result in heightened pressures for currency devaluation.
One strategy that reduces country risk is to monitor the movement of the markets and economic structures toward free and competitive markets. The Fraser Institute annually rates the economic freedom of countries, taking into consideration five major areas: size of government, which includes expenditures, taxes and enterprises; legal structure and the security of property rights; access to sound money; freedom to trade internationally; and regulation of credit, labor and business. As a final outcome of its assessment process, the Economic Freedom of the World (EFW) rating is measured on a scale from 1 to 10 with the higher value indicating the greater freedom. In its recent annual report, the EFW provided current ratings and historical values of the index. Comparing ratings from 1995 to those of 2005, significant improvement was found. Collectively, the world continues on a path to free and competitive markets according to the annual report.
Currency Risk
One of the most visible risks to an international investor is currency risk. The potential movement of exchange rates during the holding period of an investment definitely adds risk to the investment in another country should the currency of the country where the asset is located devalue.
In an ideal risk-neutral situation, the exchange rates between two countries would remain unchanged during the life of an international investment. Although such a perfect relationship is difficult to find over extended periods of time, there are ways to deal with the problem, including the following.
Hedge the currency. Examples of hedging devices include both forward contracts in the currency and currency swaps. Unfortunately, these methods to hedge risks are available on a limited basis, usually for the major currencies of the world, and have a cost associated with their use. The dollar, yen, and euro are easily hedged for extended holding periods as these are the most actively traded currencies. However, the same cannot be said for currencies of developing and transitional economies where the risk of currency movement is the greatest.
Use local currency-denominated leverage. Borrow funds in the target country to purchase the real estate asset in that country. The debt will be denominated in the same currency as the held asset and the risk of differential currencies on that portion of the investment is neutralized. In order to utilize this strategy, there must be capital available in the target country. Although the capital markets of emerging economies are improving, there remain many countries with limited ability to support this strategy.
Invest in markets where real estate leases are dollar- or euro-denominated. With the growth of multi-country trading zones and the increased activity of multinational firms, this strategy is becoming more widely available. The currency risk is transferred from the owner of the property to the tenant.
Build a portfolio of currencies. An international investment in real estate is actually two investments, one in real estate and one in a currency. By investing in multiple countries, the portfolio of currencies is diversified and currency risk is reduced.
Political and economic risks
Beyond the issue of currency risk mitigation, there are ways to mitigate some of the other political and economic risks that may be encountered when making an international investment.
When country risks are perceived to be high, a strategy of making only short-term investments can mitigate some of the risk. In the short term, the direction of the economy is much easier to forecast. In a like manner, the effects of political change are more visible over a shorter time horizon. As a result, short-term currency movements are more predictable since they are often tied to short-term economic and political health.
Given the wide variety of local practices and procedures for engaging in business and real estate transactions, the selection of a local partner for participation in a joint venture can serve to mitigate much of that risk.
Staying with the theme of “using local knowledge,” many financial services companies have global operations. Since the mid-1980s, the global financial services sector has been merging and consolidating. In the process, local operations for banking and insurance have been acquired and incorporated into the firms. These units are, in turn, a source of local knowledge for the institutional investment arms of the consolidated company.
Beyond active strategies for risk mitigation, there is an underlying trend toward economic integration sweeping across the globe. Regional trading zones have been and are being created. The income levels of developing nations are growing at rates above those of developed nations leading to a convergence of real income levels and standards of living.
International real estate investment increases risk-adjusted returns and the diversification of a portfolio. Investment-grade real estate is dispersed around the globe and should become more so. Economic convergence is likely to increase information about and the demand for international real estate.
International real estate investment involves increased risks. Country risks can be identified and substantially mitigated. Political and economic risks have been declining globally for some time and should continue to do so as the global economy integrates further.
Despite the increasing synchronization of the global capital markets, the diversification benefits of private real estate support a case for real estate and, more than ever, a case for international real estate. Private real estate presents the lowest cross-border correlation levels of all major asset classes, even in recent years. When several international markets are considered, investors can access a higher level of returns at the same level of risk. Local market characteristics continue to create differences in performance of local real estate markets, especially due to divergent economic performance. This suggests that a deep knowledge of the local markets would help to build a more efficient diversified portfolio. Private real estate may have become more global from a capital markets perspective, but in terms of market fundamentals it retains its local roots in a local economy.
Excerpted from David Lynn’s Investor’s Guide to Commercial Real Estate Investment, ULI, 2014.
David Lynn is CEO and co-founder of Everest High Income Property, a private equity real estate firm investing in income-oriented real estate, based in New York City and San Francisco.