Hedging Techniques from Volatile Emerging Markets
With interest rates going through the roof, Canadian real estate investors are exploring the best options to protect their investments. High-risk investors appear even more so exposed to these fluctuating conditions. Recently, the Bank of Canada raised interest rates by 50bps, bringing the prime rate to 7.2%; a 10-year all-time high. Beyond interest rates, however, currency devaluations and sticky inflation have begun to cast doubt on how soon a bounce back may be expected.
This is not an isolated case; there is a global economic downturn and bubble bursts. In the UK, we are seeing an interest rate hike of 5.25% following a 25bps increase; an all-time high since 2008. In China, a market downturn since 2022 coupled with a supply-driven housing crisis has resulted in racking up huge development debts to the tune of $5.2trn as of June 2021 — lulling GDP to 3% in 2022. Below, we observe the comparative global GDP growth, as well as projections for 2024 across emerging and advanced economies.
Comparative YOY growth projections for emerging and advanced economies. Source: www.imf.org
Although to much greater extremes and to a more extended duration, there is a slight semblance to the uncertainties encountered in real estate investments in emerging markets. Which brings us to the question: what are some key hedging strategies from unstable emerging markets that could be repurposed and applied to alternative investments in Canada?
Of course, emerging and developed markets exhibit vastly different behaviours with varied drivers of portfolio returns and performance; and should be treated as such. For instance, in a paper titled “Drivers of Expected Returns in International Markets” by Campbell R. Harvey, professor of International Business at Duke University, identified that emerging market returns tend to have negative coskewness compared to their developed market counterparts. This implies a disproportionately negative return on the portfolio performance of emerging markets compared to their advanced counterparts within a larger portfolio. Nonetheless, we may start to see some transferability in the underlying hedging techniques as we progress through this article.
A Borrowed Concept
Hedging is a term commonly associated with primary asset classes, where a similar concept is now being applied in the context of real estate investing. From an emerging market perspective, it is an inherent part of risk management given the large drivers of uncertainties which results in a wildly volatile part of a diversified portfolio. However, from a stable economy perspective, this may be considered an over-analysis of a potential investment, being that key drivers like interest rates are often relatively stabilized and may not require aggressive risk mitigation strategies to realize financial projections. With current realities, however, one could argue that the present market conditions warrant aggressive risk management strategies.
1. Diversification
Investing in diversified property types, geographic markets or risk profiles helps spread the risk across multiple portfolios. Unlike in stabilized economies, investing in emerging economies present a myriad of unforeseen risk exposures, and adopting a diversified portfolio becomes a necessity in managing these risks. Among the standard risks also associated with their stabilized counterparts, there is the risk of the behaviour of the parallel economy and its influence on the real economy; affecting different countries at varying degrees. Parallel economies, and invariably the informal sector, are often akin to emerging economies, making up huge aspects of it. The Economist cites the severity of this in the article, “A land of frustrated workers”, where over 50% of the Brazilian workforce is reported to be in the informal sector. In spite of this, Brazil has seen a recent unprecedented spike in foreign capital investments in the equity market to the tune of 75 billion BRI 50-day aggregate (source: Tavi Costa, Bloomberg).
However, at the core of diversification, the underlying justification for stabilized economies remains the same. For instance, investors can spread their portfolios across oil-driven and technology-driven economies to achieve a balanced risk-reward ratio. A geographic-type diversification often offers adequate cushioning, although it may fall short when exposed to global-level risks and markers of international business such as political or supply chain disruptions, as is the case of the Russia-Ukraine war. To combat this shortcoming, this strategy can be combined with a property-type diversification where a dip in one type, may be softened by a corresponding spike in the other — such as the current situation in office markets.
Since the post-pandemic era, the office market has continued to witness rising vacancy rates reaching up to 16.9% in mid-2022. As the return-to-office debate continues, there is no telling when this property type can pick back up again. To avoid these property types from turning into white elephants, investors are raising the conversation of repurposing class B and C offices into attractive industrial spaces. In essence, flexibility combined with a diversified portfolio will hedge against sensitivities to unique property type performances.
2. Long-term Outlook
Enabled by historically low-interest rates one or two years post-pandemic, numerous multi-family investments across Canada fell subject to short-term choices. We are starting to observe this demand begin to stagnate as the market struggles to adjust. To aggravate the situation, some of these investments were highly leveraged leaving investors in a compromised position with limited options like bridge financing, cost transfer to tenants, or even distress sale in extreme cases. This ultimately led investors in such compromised situations to scramble for short-term financing options in a cash-hungry economy. Interestingly, more experienced investors, for instance, high-volume syndicators are more likely to shore up liquidity in anticipation of adverse market downturns which helps effectively address short-term cash flow needs.
Although it is recommended that investors take current market conditions into consideration, a longer-term outlook reflected in financing choices or similar will effectively hedge against short-term market downturns. Instances of this can be in leveraging conservative financing options or in risk transfer strategies like strategic partnerships which allow the investor(s) to maintain a strong liquidity position during economic downturns.
3. Tiered Exit Strategy
A tiered exit strategy perhaps speaks more to the operational side of things. A combination of lack of standardized operational framework, and extremely complex deal structures make managing operations a major challenge. Broadridge aptly captures this reality in their 2023 paper, Future of Operations: Scaling Alternative Assets —
“…an investor might find herself dealing with the GPs or LPs of an oilfield in Texas who are not in tune with the day-to-day management of an investment.”
As is the case across many other industries, low visibility and lack of standardization in the value chain are the bane of an efficient operational function. It thus requires a lot more nuanced understanding of the behaviours of the physical assets and the digital transactions. Even more so, unique property types exhibit varying behaviours and require tailored-made operations. For instance, on the development side, on-site activities tend to take on a life of their own in a somewhat adaptive and practical approach to problem-solving. In essence, low visibility becomes one of the recurring challenges for risk management and investment planning, although this extends outside the scope of this article.
A tiered exit strategy is a structured and dynamic investment plan based on assessed market conditions at varying stages of the investment. The goal here is to minimize losses, effectively manage risks and optimize returns. In lay terms, how can the execution be tiered such that the project provides reasonable returns at multiple phases, and be flexible enough to cut minimal losses should dynamic macroeconomic conditions render the investment returns obsolete?
A visual representation of what expected returns at exit overtime could look like for a value-add investment with a tiered strategy. Here, we have forecasted a peak average return of a generous 20% at the optimal period. Source: www.uchechiede.com
Above, a disposition assessment can be conducted in the pre-optimal window to evaluate one’s position in relation to projected long-term property performance. Depending on the outcome, and if a market downturn is expected in the long run, the investor can opt for partial sales or to outsource operations to a third party. Of course, a short-term exit is not recommended and only becomes relevant in extreme situations or in sharp twists of events of a global nature, for instance, the effect of the pandemic on office buildings.
An instance of this, from the development side, was with a value-add investor with the goal of the adaptive remodelling of a 60-unit upscale boutique bed-and-breakfast which had been in operation well before the early 60s. This remodelling project presented a business challenge for the operational justification, beyond the architectural significance, of a tiered exit strategy. In this instance, numerous techniques such as the use of forward contracts, partnerships such as joint ventures, and conservative financing were used to achieve the overarching goal.
4. Stress Testing
Although not traditionally considered a hedging technique, stress testing lays emphasis on how scenario analyses can inform better investment decisions. This provides actionable insights into underlying vulnerabilities and guides an informed risk management strategy. While sensitivity analyses are a standardized investment due diligence, the last few years may have ushered in more complacent assumptions in underwriting, reflected in extreme hockey stick projections and/or creative financial engineering influenced by ambitious rent growth and artificially lowered cap rates for instance. We are perhaps witnessing the fallout of these investment decisions through market downturns and sticky inflation.
From an emerging market perspective, inflation rates could spike to an all-time 23% high, from a steady 11.5%, 3 years into a 7-year investment project. This will invariably result in a corresponding spike in material and labour costs, putting the syndicator in a compromised liquidity position. This would also imply that an originally budgeted finishing cost of 15% total project cost, say, could suddenly skyrocket to a whopping 45% — leading to disappointed investors and unfinished projects. In an import-heavy economy, which emerging economies often are, this is not only foreseeable but anticipated. This presents a perfect segue for the last hedging technique.
5. Currency Hedging
Commodity importation, changing geopolitical landscapes, and over-reliance on global currencies, among others, have a strong impact on the performance of an investment portfolio in emerging markets. These integrated markets are sensitive to fluctuations affecting major currency reserves like the US Dollar (USD) or the Euro (EUR). This, in turn, results in a significant shift in the local market, to a larger degree compared to their international counterparts, in the event of a global market shift, for instance, the global supply chain crisis. The local economic fluctuations may manifest themselves in the form of inflation rates or trade balances.
While the currency risk exposure in emerging and stabilized markets are vastly different, the underlying principles remain the same. For Canada, lingering currency devaluations becomes a key consideration, especially in the construction industry. While not exclusively a result of currency devaluations, the price of lumber rose to almost twice its original value pre-2021. These costs have to be absorbed into the business in one way or another.
Shifting exchange rates may not be all bad, generally speaking. Export-heavy industries like oil and gas may benefit from this market adjustment in a situation like earlier this year, where the Canadian currency devaluated to 1.375 CAD per USD. However, for real estate, business and financing costs will see an upward trend as a result — giving rise to a less-than-ideal situation.
Loonie per dollar cost in early 2023. Source: Bloomberg
For investors with property portfolios across multiple countries, say Canada and the USA, a spike in costs due to currency devaluations or exchange rates can be effectively hedged against with the use of instruments like futures to lock in potential costs with the option to trade at a predetermined price in the future irrespective of market fluctuations. High-volume syndicators would also be in a great position to leverage these instruments with additional cost savings achieved through economies of scale. As is often the case in emerging markets, this instrument can be effectively combined with other intricate business arrangements such as joint ventures, or strategic supplier relationships, giving rise to an advantageous cash position in the event of a downturn.
Key Takeaway
While some of these techniques may only be practical for certain investor groups, such as high-net-worth investors, and in off-market deals or cross-border investments, the average investor may extract a few key learning points from here. It is worthy of note that some of these hedging techniques involve wildly speculative financial instruments, like futures, and would require a deep understanding of the market and underlying assets to effectively leverage them.
It also goes without saying that understanding the risk landscape is crucial to proactively strategize to optimize gains and minimize losses. For alternative asset classes like real estate, the severity of the need directly correlates with the investor’s risk tolerance. A combination of these techniques and more will be key to weathering the current landscape and feeding the bottom line.
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