Description
International investing is not new to the investment community. It is, however, relatively new to the real estate community. Significant cross-border investment in real estate by institutional investors did not occur until the 1980s.
Prudential Real Estate Investors
International Real Estate Investment:
Digests of Research Papers from an
Investor’s Perspective
Youguo Liang, Ph.D. (973) 683-1765 [email protected]
Robert Hess, Ph.D. (973) 683-1689 [email protected]
Willard McIntosh, Ph.D. (973) 683-1793 [email protected]
November 1997
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Table of Contents
Introduction 1
The International Equity Perspective 3
Why Invest in Real Estate Internationally? 4
International Real Estate: Low Correlations and Diverse Return Opportunities 6
The Home Country Bias 9
Country Risk Assessment 10
Currency Hedge 13
Emerging Real Estate Markets: A Case Study for China 14
Introduction
International investing is not new to the investment community. It is, however, relatively
new to the real estate community. Significant cross-border investment in real estate by
institutional investors did not occur until the 1980s. The experience was not particularly
pleasant for many investors because their initial foray into another country’s property
market coincided with downturns in most of the developed markets. U.S. institutional
investors largely avoided the emerging property markets in Asia, Europe, and the
Americas until the 1990s because of perceived high risk and strong institutional barriers.
Driven by the need to increase returns through expanded investment opportunities and a
desire to diversify, investors’ interest in international property markets is on the rise again.
Armed with more information and a better understanding of the issues surrounding
international investment, investors will be able to make more informed decisions this
round.
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This collection of digests of research papers is intended to contribute to the learning
process of investors and managers alike. Cited articles are written by both academics and
practitioners, and they are chosen according to relevance and readability. We will provide
readers with copies of these articles if so requested; most of them can be read with little
knowledge of statistics and mathematical modeling.
These summaries are organized into the following seven categories.
The International Equity Perspective – First and foremost, we learn from international
investments in stocks. Diverse returns and low correlations between country markets
provide opportunities to enhance return and to reduce risk. Asset allocation schemes are
developed in the domestic, developed, and emerging categories to assist globalizing
institutional portfolios.
Why Invest in Real Estate Internationally? – The reasons are the same as those used to
justify any investment: enhancing return and/or reducing risk. International markets
expand the investment universe and investors’ horizon. International investors are
constantly being reminded that they have limited local information, but they also have a
wider perspective.
International Real Estate: Low Correlations and Diverse Return Opportunities – We
have no reason to believe that these opportunities will not continue in the future.
The Home Country Bias – That is, investors tend to invest disproportionally more in their
home countries. Part of the bias can be explained by real world barriers against
international investing. Much of this bias, however, is simply a result of inertia.
Country Risk Assessment – Properly assessing country risk is as important as searching for
opportunities. Fortunately, there are sources of help such as the International Country
Risk Guide that have been demonstrated to provide valuable risk information for country
markets.
Currency Hedge – Currency risk is unique to international investment. There are
conflicting theories on hedging currency risk. As a practical guide, if foreign assets are a
small portion of the fund, it is not worthwhile to hedge the risk. Otherwise hedging is a
serious issue. It is conclusive, however, that the hedge decision should be made at the fund
or portfolio level.
Emerging Real Estate Markets: A Case Study for China – China is used as an example to
demonstrate that there are enormous opportunities in foreign markets. A case in point is
China’s urban housing market: China’s urban population is fast approaching the combined
population of the U.S. and Japan. There are likely to be a number of opportunities for
earning superior risk-adjusted returns in the vast land of China.
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The International Equity Perspective
Twenty Years of International Equity Investing, by Richard O. Michaud, Gary L.
Bergstrom, Ronald D. Frashure, and Brian K. Wolahan, The Journal of Portfolio
Management, Fall 1996
Still a route to higher returns and lower risks? Yes.
The case for global investing: The argument for global portfolio diversification – as laid
out in the mid-1980s – centered on decreasing portfolio risk or increasing portfolio
expected return relative to a comparable domestic portfolio. The seed of the argument was
planted in Markowitz’s classic work on portfolio efficiency.
Global market return: Twenty country market returns for January 1959-December 1975
and January 1976-December 1995 in U.S. dollars are calculated. The returns are diverse.
For example, in the more recent period, the U.S. market ranks ninth, with an annualized
compound return of 14.2%. Hong Kong provided the strongest return of 20.1% annually,
while Spain lagged, with a 6.1% annual return. There is essentially no relationship
between returns in the pre- and post-1975 intervals. Thus simple extrapolation of
historical returns has not been an effective methodology for predicting future country
returns during the past two decades. The range of returns illustrates that substantial
opportunities exist to enhance returns from global investment.
Global market correlation: The correlations of the foreign market returns with U.S.
returns are generally less than 0.5 with the notable exception of Canada. The average
correlation of the fifteen major foreign country markets with the U.S. is about 0.35,
indicating potential for a significant diversification benefit. Some have opined, however,
that the correlations between global equity markets have been increasing recently. This
view may have its origin in the belief that world equity markets are increasingly subject to
common influences, and that global economies are becoming more highly synchronized.
The results indicate, however, that it is not at all clear from empirical data that there has
been any significant secular trend in correlations. A related claim is that international
diversification is not as effective during declining markets, reducing the benefit when it
would be most advantageous. The empirical evidence indicates otherwise, that there has
not been a significant reduction in the benefits of international diversification, even during
periods when the U.S. market has declined.
Emerging markets: Including emerging markets in a global portfolio can provide
numerous opportunities to add value. Such countries represent investment opportunities
today in the same way that many now-developed markets did twenty years ago. Emerging
markets present many interesting challenges as well as opportunities to institutional
investors. There is no particular homogeneity to the emerging country markets. Long-term
correlations, both to other emerging markets and to developed ones, have been quite
varied. Differences in economic development, industry composition, and local political
factors, as well as fundamental perceptions of the sources of economic growth, have led
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to substantial divergence in return even over long periods of time. Of course, such risks
are likely to be consistent with the investment opportunities available to thoughtful and
disciplined investors. For example, over the 1986-1995 period, the U.S. market returned
15% annually. Most of the developed markets including the Japanese market have
returned in the low to mid-teens percent per annum. A sample of ten emerging markets,
Argentina, Brazil, Chile, Greece, Korea, Malaysia, Mexico, The Philippines, Taiwan, and
Thailand, have returned an average of 35% annually over the same period, with the
highest of 45% and the lowest of 19%. The U.S. market, however, has a volatility,
measured by standard deviation, of only 14.9%. By comparison, the average volatility of
these ten emerging markets is 43%.
Currency hedging: Investment policy ideally depends on the nature of a fund’s liabilities,
funding status, institutional risk tolerance and investment objectives. Many pension plan
sponsors are likely to find that short-term portfolio risk is an important corporate concern
in the context of asset management monitoring, projecting cash flows, and overall
corporate objectives. In such cases, investment horizon, risk aversion, and other
assumptions are likely to impact hedging policy. From a purely investment perspective, a
zero hedging policy benchmark may be desirable for funds with roughly 20% or less of
non-domestic assets. If the percentage of non-domestic assets is significantly larger, a non-
zero hedge policy may be appropriate in order to reduce some of the short-term currency
risk. As a simple heuristic, a hedging benchmark of 50% of non-domestic assets may be a
useful compromise policy that balances a pension plan’s long-term investment interests
with shorter-term corporate and plan funding requirements.
Global equity asset allocation: It is of interest to many global equity investors to define an
efficient allocation among the major global equity asset classes: domestic, developed, and
emerging markets. The “index” portfolio has a 40/50/10% weighting in domestic,
developed, and emerging markets, and presents an asset allocation roughly consistent with
the current capitalization of a comprehensive global equity index. While standards are
changing rapidly, a “typical” U.S. institutional global equity portfolio might include
approximately 20% of assets in non-U.S. markets. While an efficient portfolio that is
consistent with institutional global equity mandates cannot be singularly delineated, it most
likely will have at least a 10% allocation to emerging markets.
Why Invest in Real Estate Internationally?
Can Foreign Real Estate Investment Be Successful?, by Andrew E. Baum, Real Estate
Finance, Spring 1995
Driven by the desire to enhance diversification and pursue favorable return prospects,
North American, European and Japanese institutions began to seriously consider
international real estate investment in the mid- to late 1980s. According to a recent survey
that gathered 43 responses from large institutional investors, 45% of them included
overseas property in their investment strategies and planned to maintain active overseas
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portfolios in the future. Their current allocations average 12% of real estate assets in
overseas property, but the target weight averages 21%. According to surveys, the most
popular three reasons for international property investment are diversification, higher
yields, and lower risk. Other reasons include the globalization of the occupier markets
(i.e., major tenants) and lack of opportunities in the local market.
The attraction of foreign real estate investing is clearly driven by one or both of two
objectives: 1) the possibility of obtaining superior risk-adjusted expected returns by
making opportune investments; and 2) the potential to reduce portfolio risk by
diversification.
Consider first the opportune investment motivation. Virtually by definition, this objective
envisions taking advantage of some aspect of the inefficiency of the functioning of local
real estate markets in the target country. Well-advised foreign investors should look for
two factors in particular to ferret out such opportunities: perspective and liquidity.
Contrary to accepted belief, a foreign investor can actually have an information advantage
over the local domestic market participants, in that the foreign investor may possess a
broader perspective. While local players will always have superior information about local
property and rental market conditions, exposure to the world asset markets can give the
foreign investor a unique perspective from which to view the relative investment value of
local assets.
Mismatches in liquidity around the world can cause booms and slumps, and occasionally
cheap and expensive markets, often at different times in different places. The global player
free of the capital supply constraint imposed by the local liquidity shortage, and with a
wider choice of target markets, can time transactions more effectively than the local
investor.
The diversification argument is easy to make for overseas real estate. There is abundant
evidence to suggest low correlations between global real estate markets.
In addition to the theoretical attractions of international real estate investing, the foreign
investor also faces some unique challenges and problems. The perspective advantage,
which can help foreign investors relative to their local counterparts, may be counteracted
by information disadvantages at the local level. This problem is not unfamiliar to
institutional investors. According to a recent survey, 81% of respondents say lack of local
expertise is the major problem affecting international real estate investment. Other
problems involve identifying and managing overseas properties, cultural, legal and tax
hurdles. A strong local partner may help alleviate these problems. Good research
information and appropriate investment vehicles can help minimize information risks and
specific risks.
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Additional References
The John Dillinger Approach, by Karen Stearns, The Institutional Real Estate Letter, May
1996
• Someone once asked John Dillinger, “Why do you rob banks?” The gangster smoothly
relied, “Because that’s where the money is.” While making the initial foray into any
new market or investment climate can be frightening, investment in Asia carries with it
an enormous carrot – that of outstanding returns and tremendous potential.
• Besides the economic/performance/market cycle risks faced by real estate investors in
the U.S., Asia brings with it additional risks unique to a foreign emerging market.
These risks include political, currency, tax, legal, and overbuilding.
Going Global, by Kenn Stearns, The Institutional Real Estate Letter, October 1994
• Superior yields and diversification are the two reasons cited most often by domestic
pension funds that invest in international products.
• In general, one can’t expect to increase yield without assuming more risk. In
international investing, there are at least four: political risk; exchange rate risk;
taxation; and lack of local market knowledge.
Overseas Property Investments: How Are They Perceived by the Institutional Investor?,
by Elaine M. Worzala, Journal of Property Valuation and Investment, V12, No.3, 1994
International Real Estate: Low Correlation and Diverse Return Opportunities
Does International Diversification Work Better for Real Estate than for Stocks and
Bonds?, by Piet M.A. Eichholtz, Financial Analysts Journal, January/February 1996
The past decade has seen a surge in international equity and fixed-income investments, but
most real estate investors still stick to their own countries. An international investment
strategy also works for real estate. In fact, international diversification is more effective in
reducing the risk of real estate portfolios than of common stock and bond portfolios. Tests
of international correlation matrixes of real estate returns, common stock returns, and
bond returns indicate significantly lower correlations between national real estate returns
than between common stock or bond returns.
The data used in the study are time series of property share, common stock, and bond
index returns. The property share indexes maintained by The Limburg Institute of
Financial Economics represent real estate returns. Only total country indexes of some of
the more important markets are examined. These countries are France, the Netherlands,
Sweden, the United Kingdom, Hong Kong, Japan, Singapore, Canada, and the United
States. The study period is for January 1985 to August 1994. Property indexes are
compared with Morgan Stanley Capital International’s common stock indexes and with
Salomon Brothers’ bond performance indexes.
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The correlations between the property share indexes in the various countries are, on
average, lower than those between the common stock and between the bond indexes.
Each property share correlation is lower than its corresponding stock correlation, and with
only one exception, this is also the case for property share and bond correlations. The real
estate securities’ correlations range from 0.07 to 0.53, the stock correlations vary between
0.24 and 0.79, and the bond correlations are between 0.19 and 0.76.
Statistical tests performed on the data reject the hypothesis that international correlations
of property share returns equal those of common stocks and those of bonds. These
findings suggest that international property share investments reduce portfolio risk better
than international common stock and international bond investments. In other words,
international diversification is more effective for real estate securities portfolios.
Real estate securities delivered returns as high as 33.4% per annum in Hong Kong and as
low as 2.2% per annum in the Netherlands (see Exhibit 1 below).
Exhibit 1. Real Estate Securities Return
Annual Return: 1985-94
Hong Kong 33.4
Singapore 21.2
Japan 12.5
United States 12.3
United Kingdom 9.9
France 8.6
Sweden 3.4
Netherlands 2.2
Source: Calculated from Eichholtz’s data
Commercial Real Estate Prices and Stock Market Returns: An International Analysis, by
Daniel C. Quan and Sheridan Titman, Financial Analysts Journal, May/June 1997
The increasing presence of real estate and foreign stocks in the portfolios of institutions
may have been motivated in part by academic studies that suggest that covariance between
U.S. stocks and foreign stocks and U.S. stocks and commercial real estate are quite low.
Thus foreign stocks and real estate should provide diversification to portfolios invested
primarily in U.S. stocks. Overseas investment may also be motivated by the search for
high yields or high capital appreciation. Exhibit 2 shows price appreciation of commercial
real estate for the seventeen markets over 1988-1994. The Asian markets have performed
exceptionally at the same time when most of the developed markets were experiencing a
real estate recession.
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Exhibit 2. Annual Price Change of Real Estate: 1988-1994
Local Currency U.S. Dollar
Indonesia 30.0 24.7
Hong Kong 25.9 26.0
Taiwan 19.7 22.0
Malaysia 15.7 14.2
Singapore 13.2 17.9
Italy 7.5 5.9
Germany 4.7 6.0
The Netherlands 3.2 4.5
Belgium 2.7 5.3
Spain 0.5 0.7
France -0.4 0.5
Australia -2.4 0.3
United Kingdom -3.8 -4.8
Canada -4.6 -4.6
New Zealand -5.6 -5.0
United States -8.4 -8.4
Japan -9.4 -5.7
Source: Quan and Titman
Exhibit 3 shows correlations of U.S. real estate capital returns with foreign real estate
capital returns over 1987-94. All correlations are calculated using local currency returns,
so that the correlations are not the result of exchange rate changes. The correlations range
from -0.9 for Hong Kong to +0.9 for the United Kingdom. The average correlation is
only 0.11, indicating significant diversification potential of international real estate
investing.
Exhibit 3. U.S. Foreign Real Estate Capital Return Correlations: 1987-94
Correlation with the U.S.
Hong Kong -0.91
Malaysia -0.73
Singapore -0.57
Indonesia -0.53
Germany -0.38
Taiwan -0.27
Italy -0.18
The Netherlands -0.16
Belgium 0.07
France 0.46
Spain 0.60
New Zealand 0.84
Canada 0.85
Australia 0.85
Japan 0.87
United Kingdom 0.92
Average 0.11
Source: Quan and Titman
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The database used to calculate returns and correlations consists of indexes of prime office
market properties for cities in seventeen countries. The countries (cities) are Australia (all-
cities index), Belgium (Brussels), Canada (all-cities index), France (Paris), Germany
(Dusseldorf, Frankfurt, Hamburg, Munich), Hong Kong (Hong Kong), Indonesia (Jakarta,
Italy (Milan), Japan (Tokyo), Malaysia (Kuala Lumpur), the Netherlands (Amsterdam),
New Zealand (Auckland), Spain (Madrid), Singapore (Singapore), Taiwan (Taipei), the
United Kingdom (London), and the United States (all-cities index).
Additional References
The Effect of International Real Estate Securities on Portfolio Diversification, by Jacques
N. Gordon, Todd A. Canter, James R. Webb, working paper presented at the 1997
American Real Estate Society Annual Meeting
International Diversification of Property Stock – A Singaporean Investor’s Viewpoint, by
Kwame Addae-Dapaah and Choo Boon Kion, Real Estate Finance, Fall 1996
Diversification Potential from Real Estate Companies in Emerging Capital Markets, by
Christopher B. Barry, Mauricio Rodriguez, and Joseph B. Lipscomb, The Journal of Real
Estate Portfolio Management, V2, No.2, 1996
An Examination of International Real Estate Equity Markets, by Steven Laposa, working
paper presented at the 1996 American Real Estate Society Annual Meeting.
The Home Country Bias
Why Do Pension and Insurance Portfolios Hold So Few International Assets?, by Mark
W. Griffin, The Journal of Portfolio Management, Summer 1997
Investors seem to bias their investments towards the domestic country, despite the
prospects for significant gains by diversifying internationally. This phenomenon has come
to be known as the home country bias.
Institutional investors, pension funds and insurance companies alike, hold portfolios that
appear to defy the modern portfolio theory. The most prominent characteristic of an
average, U.S.-based insurance company or pension fund portfolio is the high
concentration of domestic securities. For example, international bonds represent only
0.5% of the average insurance company’s bond portfolio and 4.6% of the average
pension fund’s bond portfolio; international equity accounts for only 3.0% and 15.8%,
respectively, of the average insurance company and pension fund’s equity portfolios. The
foreign components of the portfolios are too small relative to the composition of the
investment universe and to the allocations suggested by modern portfolio theory. In order
to justify the home country bias, the excess returns of the U.S. securities over international
ones would have to be extremely high.
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There are several explanations for the home country bias. One possibility is that investors
desire to hedge inflation at home. A second hypothesis is that prevailing institutional
barriers to foreign investment are sufficiently large to explain the bias. A third hypothesis
is that transaction costs for investing abroad and taxes on income from foreign assets
might also be a reason for the bias. However, it is unlikely that these three factors are
sufficiently strong to account for the bias observed empirically in portfolios.
This article adds a fourth hypothesis to explain the home country bias. If the risk of an
asset allocation is measured relative to liabilities, a domestic concentration within equities
is warranted, with even a higher domestic concentration of bonds warranted. This result
depends to some extent on the length of the liabilities, with longer liabilities leading to a
higher domestic concentration than shorter liabilities. The rational is that domestic security
returns are more highly correlated with liability changes than international returns, thus
ensuring higher allocations.
Additional References
Home Bias in Equity Portfolios, Inflation Hedging, and International Capital Market
Equilibrium, by Ian Cooper and Evi Kaplanis, Review of Financial Studies, Spring 1994
Country Risk Assessment
Political Risk, Economic Risk, and Financial Risk, by Claude B. Erb, Campell R. Harvey,
and Tadas E. Viskanta, Financial Analysts Journal, November/December 1996
Given the increasingly global nature of investment portfolios, an understanding of country
risk, which is linked to expected return, is very important. This article provides sources of
this risk information and examines the economic content of five specific measures of
country risk (four from the International Country Risk Guide’s political, financial,
economic, and composite risk indexes and one from Institutional Investor’s country credit
rating). The results suggest that country risk measures are correlated with future equity
returns. In addition, such measures are highly correlated with equity valuation measures.
Many services measure country risk including:
Bank of America World Information Services,
Business Environment Risk Intelligence,
Control Risks Information Services,
Economist Intelligence Unit,
Euromoney,
Institutional Investor,
Standard and Poor’s Rating Group,
Political Risk Services: International Country Risk Guide,
Political Risk Services: Coplin-O’Leary Rating System, and
Moody’s Investors Service.
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Each of the index or rating providers must amalgamate a range of qualitative and
quantitative information into a single index or rating. Institutional Investor and
International Country Risk Guide are two of the foremost providers of risk ratings.
Institutional Investor country credit rating takes into consideration critical risk factors
such as debt service, political outlook, economic outlook, financial reserve/currency
account, trade balance, foreign direct investment, fiscal policy, inflow of portfolio
investments, access to capital markets, etc. International Country Risk Guide compiles
data on a variety of political, financial, and economic risk factors to calculate risk indexes
for each of these categories as well as a composite risk index. Five financial, 6 economic,
and 13 political factors are used. The critical financial factors are: loan default or
unfavorable loan restructuring, delayed payment of supplier’s credits, repudiation of
contracts by governments, losses from exchange controls, and expropriation of private
investments. Inflation, debt service, international liquidity, foreign trade collection
experience, current account balance, and parallel foreign exchange rate market indicators
are the six critical factors for the economic risk rating. Some of the political risk factors
are: economic expectations versus reality, economic planning failures, political leadership,
external conflict, and corruption in government.
Do risk indexes contain information about future expected returns? Two analyses are
conducted to answer the question. First, a portfolio of countries that experienced a
decrease in risk rating (becoming more risky) and a portfolio of countries that experienced
an increase in risk rating (becoming less risky) are formed. These risk measures contain
meaningful information because excess returns can be earned by forming arbitrage
portfolios. Supplemental time-series/cross-sectional regressions are run to measure the
amount of information contained in each metric. The financial risk measure contains the
most information about future expected returns and the political risk measure contains the
least. In addition, country risk indexes are highly correlated with the fundamental
attributes of a market such as price to earnings and book to price ratios. Thus securities
markets reflect country risk levels: riskier countries are expected to provide higher returns.
Demographics and International Investments, by Claude B. Erb, Campbell R. Harvey,
and Tadas E. Viskanta, Financial Analysts Journal, July/August 1997
Demographics data contain information about the risks and expected returns of
international markets.
An example is the United States, for which lengthy time series of data exist for the
financial markets and for population trends. Time-series correlations between each age
weight (ratio of population in an age group to total population) and U.S. real equity
returns are calculated. The highest correlations are found for the 28- to 46-year old range.
That is, an increase in the proportion of the population in this age range affects equity
returns positively. This range includes the prime working age, which is likely to be the
most productive.
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Indeed, demographics influence the prices of many real and financial assets. However, the
linkage between demographics and capital markets is more difficult to identify in an
international framework. Aside from the issues of market integration, countries with the
highest average-age increase are generally those with the lowest average age; that is,
countries with relatively young populations seem to age more rapidly than those with
relatively old populations. Aging in a global context does not simply mean that more
people are retired; it could mean, for example, that people do not die, on average, during
middle age.
An example is the United States, for which lengthy time series of data exist for the
financial markets and for population trends. Time-series correlations between each age
weight (ratio of population in an age group to total population) and U.S. real equity
returns are calculated. The highest correlations are found for the 28- to 46-year old range.
That is, an increase in the proportion of the population in this age range affects equity
returns positively. This range includes the prime working age, which is likely to be the
most productive.
Indeed, demographics influence the prices of many real and financial assets. However, the
linkage between demographics and capital markets is more difficult to identify in an
international framework. Aside from the issues of market integration, countries with the
highest average-age increase are generally those with the lowest average age; that is,
countries with relatively young populations seem to age more rapidly than those with
relatively old populations. Aging in a global context does not simply mean that more
people are retired; it could mean, for example, that people do not die, on average, during
middle age.
The evidence suggests that the demographic attributes such as average age and life
expectancy contain some information about future expected returns. Give that the
demographics variables are slow moving and highly persistent, it makes little sense that
they can be used to forecast short-horizon returns. Instead, these variables are found to
contain information about long-horizon returns.
In addition, the analysis suggests a significant relationship between the demographic
variables and a number of risk measures used in the practice of country risk analysis. For
example, 61 percent of the cross-sectional variation in 45 countries’ political risk ratings
can be accounted for by the rate of average-age increases. This finding supports the
contention that demographic data reveal information about risk exposure in an
international context.
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Additional References
Risk and Real Estate Investment: An International Perspective, by Tom G. Geurts and
Austin Jaffe, The Journal of Real Estate Research, V 11, No.2, 1996
Political Risk in Emerging and Developed Markets, by Robin L. Diamonte, John M Liew,
and Ross L. Stevens, Financial Analysts Journal, May/June 1996
Country Risk and Global Equity Selection, by Claude B. Erb, Campbell R. Harvey, and
Tadas E. Viskanta, The Journal of Portfolio Management, Winter 1995
Currency Hedge
The Currency Hedging Decision: A Search for Synthesis in Asset Allocation, by Gary L.
Gastineau, Financial Analysts Journal, May/June 1995
One of the most important papers in the currency-hedging debate is by Andre Perold and
Evan Shulman (The Free Lunch in Currency Hedging: Implication for Investment Policy
and Performance Standards, Financial Analysts Journal, May/June 1988). This paper
argued that, from a long-term perspective, currency should be viewed as an asset with
zero expected return. Thus, any exposure to currencies other than the investor’s home
currency should be viewed as an active investment decision. Perold and Shulman conclude
that, even if the expected return is zero, the currency asset is likely to be part of a
diversified portfolio. Therefore, the basis for evaluating manager performance should be a
currency-hedged portfolio. Even those who consider the Perold and Shulman zero
expected return premise an oversimplification and who disagree with their conclusion,
generally accept the notion that an appropriate performance benchmark is a currency-
hedged portfolio.
At the other extreme of the currency-hedging debate is the work of Kenneth Froot
(Currency Hedging over Long Horizons, working paper 4355, National Bureau of
Economic Research). Based on studies covering a 200-year period, with special attention
to the past 20 years, Froot argues that real returns from currencies are mean reverting.
Froot’s calculations show that the value of hedging virtually disappears by the end of an
eight-year period. He argues that unless short-term currency effects are of critical concern,
investors are better off without currency hedging because hedging will add costs in the
long term. This argument may overlook one of the risk-reduction/return-enhancement
advantages of currency diversification management.
Perold and Shulman at one end and Froot at the other are widely cited advocates of the
extremes of currency-hedging policy. The giant, roaming the middle range, is Fisher Black
(Universal Hedging: Optimizing Currency Risk and Reward in International Portfolios,
Financial Analysts Journal, July/August 1989). For reasons based on the characteristics of
percentage relationships among asset and currency returns, and most importantly on the
structure of the global capital asset pricing model, Black argues for the existence of a
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single, universal currency-hedge ratio that should be applied to all cross-border positions
in the absence of specific information and conviction to the contrary. Setting aside the
highly restrictive assumptions on which the universal hedge calculation is based, the value
of the universal hedge ratio is a function of several unstable observed variables. As a
consequence, the value of the hedge ratio can vary considerably over time. In examples
Black provides the appropriate ratio ranges from a low of 0.30 to a high of 0.77.
The universal hedging ratio is too unstable to be useful, but a simple 50 percent hedged/50
percent unhedged benchmark is an improvement over either fully hedged or unhedged
benchmarks because it calls attention to the potential gains from well-considered currency
allocations. This halfway benchmark helps emphasize that an active manager would not
ignore stock or bond allocations and should not ignore currencies. Based on the mechanics
behind Black’s argument, the 50/50 benchmark is not a bad policy for a passive manager
and it is a reasonable starting point for an active currency manager.
In the United States, currency-hedged benchmarks are the accepted norm, but the AIMR
performance presentation standards allow for alternative currency benchmarks if an
investor and a manager want to use them. Many investors and their managers have agreed
on a 50 percent hedged/50 percent unhedged benchmark or on an unhedged benchmark.
Additional References
Currency Swaps for Hedging a Realistic International Real Estate Investment: Do They
Work?, by Richard D. Johnson, Elaine M. Worzala, and Colin M. Lizieri, working paper
presented at the 1997 American Real Estate Society Annual Meeting
Asset Allocation with Hedged and Unhedged Foreign Assets, by Jorion Philippe, Journal
of Portfolio Management, Summer 1989
Emerging Real Estate Markets: A Case Study for China
Latent Demand for Urban Housing in the People’s Republic of China, by Jeffrey S. Zax,
working paper, University of Colorado at Boulder, 1997
This paper explores the differences in family characteristics and dwelling size between
those who reside in state-owned and those in own-built housing in China. State-owned
dwellings are allocated by the state. Own-built housing is allocated by free markets. The
mechanism that assigns state-owned housing to urban families produces a very different
match between family characteristics and housing space than does a mechanism based on
optimizing expressions of family housing demand. The dwellings that families want are
much larger than bureaucrats think they should have. For example, sample families in
state-owned dwellings have an average total space of 39 square meters and those with
similar characteristics in own-built dwellings would like to have 68 square meters.
Data were collected from a survey of 9,009 urban families in China. Using this data a
special type of regression is run to determine the propensity to choose own-built rather
15
than state-owned housing. Regression equations also determine the size of dwelling a
family would require based on characteristic explanatory variables such as employment
types and incomes.
The demand for own-built housing in China is growing. This will open many
opportunities for investment in areas such as housing development. Because the demand
would be for larger domiciles, continued reform would generate a strong demand in terms
of housing units and space.
Benchmark Pricing Behavior of Land in China’s Reforms, by Ling Hin Li and Anthony
Walker, Journal of Property Research, 1996, pp.183-196
Following the open door policy, China is allowing a major and valuable national resource,
namely land, to be privatized in the market. Land has not been allocated according to the
market since the Communist Party took power in 1949. Without extensive market
activities it has become imperative for both central and local governments to devise
guidelines when selling land to developers who have found great potential in this market.
After initial pilot studies in some cities, a benchmark pricing model was finally devised to
provide guideline land prices.
The benchmark price is the average price level established within a specific time period in
a particular area/locality for a particular land use. It is set by the government land
management departments and the state valuation committee according to transaction data
as well as expected revenue from land.
To turn benchmark prices from being a baseline reference into a more representative
measure of the actual market means, more frequent updates of the benchmark price tables
are needed. This is not easy given the lack of a relatively efficient real estate market in
China. The observed divergence in land prices achieved under different land sale
procedures reflects the immaturity and inefficiency of the market.
This paper is particularly relevant to developers because it details the historical and current
land valuation policies in China and their deficiencies.
Spatial Trends of Urban Development in China, by M. Atef Sharkawy, Xiangqun Chen,
and Frederik Pretorius, Journal of Real Estate Literature, 1995, pp. 47-59
Urbanization and its spatial distribution have witnessed dramatic shifts since China
adopted its open door policy in 1978. Based on statistical analysis, this study suggests that
foreign investment and rural enterprise formation are the most significant variables
affecting urban development in China. Using a geographic information system, this
research finds that spatial distribution of development follows a historic pattern: along the
coastal zone, intensified in deltas and extending inland along rivers. The pattern of
development was initially concentrated in special economic zones, economic development
zones, and priority development areas which serve as industrial export platforms such as
16
Guangdong and Hainan serving Hong Kong, and Fujian and Zhejiang serving Taiwan. The
industrial sector soon helped the agricultural and trade/retail sectors and was then joined
by an active public and private service sector.
This study concludes by projecting the distribution of the most likely future development
in China. Intensive urbanization and development in the future will be concentrated in
three areas. First, the current intensive development areas in Hainan and the Guangzhou-
Hong Kong area will move inward to the Pearl River Delta. Second, Shanghai will lead
the Yangtze River Delta into rapid urbanization. Third, the Beijing-Tianjin area will lead
its neighbors to a higher development intensity.
Implications of China’s New Property Law on Real Estate Investments, by Lim Lan Yuan,
Real Estate Finance, Fall 1995
In 1994, the Chinese government introduced the latest legislation on real estate: The Law
of the People’s Republic of China on Urban Real Property Administration. It took effect
on January 1, 1995. This law is designed to systematically regulate the whole range of real
estate activities in the country: buying, selling, leasing, mortgage, and development. The
new law sets out the general provisions governing the granting and allocation of land-use
rights, property development, transfer of property, title registration, the mortgage and
leasing of property, and legal penalties for infringement of the law.
There are several general themes in the new law. A significant attempt has been made to
dampen property speculation and to ensure full market disclosure of all transactions. The
procedures for the granting of land-use rights and title registration have been streamlined,
and the division of the functions and powers of government departments in charge of land
administration, urban planning, and building administration has been clarified. However,
some flexibility has been reserved for the State Council to create detailed administrative
rules to resolve controversial problems and for the provisional government to formulate
working rules based on their respective local conditions.
17
Additional References
China Housing Investment, Prudential Investments research report, 1997
Asia, Urban Land Supplement, May 1997. In particular, Investing in Asian Pacific Real
Estate by Kenn Stearns and China: An Emerging Economic Giant by Robert H. Edelstein
Housing Rent and Occupational Rank in Beijing and Shenyang, People’s Republic of
China, by Yanxiang Anthony Gu and Peter F. Colwell, Journal of Property Research,
1997, pp. 133-143.
Privatization of the Urban Land Market in Shanghai, by Ling Hin Li, Journal of Real
Estate Literature, 1997, pp. 161-168
Land Use Rights Reform and the Real Estate Market in China, by Anthony
18
Reports From Prudential Real Estate Investors Investment Research
Forecasting Office Space Demand - November 1997
China Housing Investment - November 1997
International Real Estate Investment: Digests of Research Papers from an Investor’s
Perspective - November 1997
Senior Housing: An Emerging Institutional Investment Industry - August 1997
Tracking a Capital Market Transformation: Public Market Commercial Real Estate
Penetration - August 1997
The Evolution of Public and Private Market Investing in the New Real Estate Capital
Markets - June 1997
The Change in Prudential’s General Account Real Estate Investment Strategy: Is It
Appropriate for Pension Fund Investors? June 1997
“Development and Implementation of an Integrated Portfolio Management Paradigm” -
Spring 1997 (reprint from Real Estate Finance)
Housing: Strength and Resilience - March 1997
19
Prudential Real Estate Investors, 1997 all rights reserved.
8 Campus Drive, Parsippany, NJ 07054
Information contained herein is based on data obtained from recognized statistical
services, issuer reports or communications, or other sources, believed to be reliable.
However, such information has not been verified by us, and we do not make any
representations as to its accuracy or completeness. Any statements nonfactual in nature
constitute current opinions, which are subject to change.
doc_227150264.pdf
International investing is not new to the investment community. It is, however, relatively new to the real estate community. Significant cross-border investment in real estate by institutional investors did not occur until the 1980s.
Prudential Real Estate Investors
International Real Estate Investment:
Digests of Research Papers from an
Investor’s Perspective
Youguo Liang, Ph.D. (973) 683-1765 [email protected]
Robert Hess, Ph.D. (973) 683-1689 [email protected]
Willard McIntosh, Ph.D. (973) 683-1793 [email protected]
November 1997
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Table of Contents
Introduction 1
The International Equity Perspective 3
Why Invest in Real Estate Internationally? 4
International Real Estate: Low Correlations and Diverse Return Opportunities 6
The Home Country Bias 9
Country Risk Assessment 10
Currency Hedge 13
Emerging Real Estate Markets: A Case Study for China 14
Introduction
International investing is not new to the investment community. It is, however, relatively
new to the real estate community. Significant cross-border investment in real estate by
institutional investors did not occur until the 1980s. The experience was not particularly
pleasant for many investors because their initial foray into another country’s property
market coincided with downturns in most of the developed markets. U.S. institutional
investors largely avoided the emerging property markets in Asia, Europe, and the
Americas until the 1990s because of perceived high risk and strong institutional barriers.
Driven by the need to increase returns through expanded investment opportunities and a
desire to diversify, investors’ interest in international property markets is on the rise again.
Armed with more information and a better understanding of the issues surrounding
international investment, investors will be able to make more informed decisions this
round.
2
This collection of digests of research papers is intended to contribute to the learning
process of investors and managers alike. Cited articles are written by both academics and
practitioners, and they are chosen according to relevance and readability. We will provide
readers with copies of these articles if so requested; most of them can be read with little
knowledge of statistics and mathematical modeling.
These summaries are organized into the following seven categories.
The International Equity Perspective – First and foremost, we learn from international
investments in stocks. Diverse returns and low correlations between country markets
provide opportunities to enhance return and to reduce risk. Asset allocation schemes are
developed in the domestic, developed, and emerging categories to assist globalizing
institutional portfolios.
Why Invest in Real Estate Internationally? – The reasons are the same as those used to
justify any investment: enhancing return and/or reducing risk. International markets
expand the investment universe and investors’ horizon. International investors are
constantly being reminded that they have limited local information, but they also have a
wider perspective.
International Real Estate: Low Correlations and Diverse Return Opportunities – We
have no reason to believe that these opportunities will not continue in the future.
The Home Country Bias – That is, investors tend to invest disproportionally more in their
home countries. Part of the bias can be explained by real world barriers against
international investing. Much of this bias, however, is simply a result of inertia.
Country Risk Assessment – Properly assessing country risk is as important as searching for
opportunities. Fortunately, there are sources of help such as the International Country
Risk Guide that have been demonstrated to provide valuable risk information for country
markets.
Currency Hedge – Currency risk is unique to international investment. There are
conflicting theories on hedging currency risk. As a practical guide, if foreign assets are a
small portion of the fund, it is not worthwhile to hedge the risk. Otherwise hedging is a
serious issue. It is conclusive, however, that the hedge decision should be made at the fund
or portfolio level.
Emerging Real Estate Markets: A Case Study for China – China is used as an example to
demonstrate that there are enormous opportunities in foreign markets. A case in point is
China’s urban housing market: China’s urban population is fast approaching the combined
population of the U.S. and Japan. There are likely to be a number of opportunities for
earning superior risk-adjusted returns in the vast land of China.
3
The International Equity Perspective
Twenty Years of International Equity Investing, by Richard O. Michaud, Gary L.
Bergstrom, Ronald D. Frashure, and Brian K. Wolahan, The Journal of Portfolio
Management, Fall 1996
Still a route to higher returns and lower risks? Yes.
The case for global investing: The argument for global portfolio diversification – as laid
out in the mid-1980s – centered on decreasing portfolio risk or increasing portfolio
expected return relative to a comparable domestic portfolio. The seed of the argument was
planted in Markowitz’s classic work on portfolio efficiency.
Global market return: Twenty country market returns for January 1959-December 1975
and January 1976-December 1995 in U.S. dollars are calculated. The returns are diverse.
For example, in the more recent period, the U.S. market ranks ninth, with an annualized
compound return of 14.2%. Hong Kong provided the strongest return of 20.1% annually,
while Spain lagged, with a 6.1% annual return. There is essentially no relationship
between returns in the pre- and post-1975 intervals. Thus simple extrapolation of
historical returns has not been an effective methodology for predicting future country
returns during the past two decades. The range of returns illustrates that substantial
opportunities exist to enhance returns from global investment.
Global market correlation: The correlations of the foreign market returns with U.S.
returns are generally less than 0.5 with the notable exception of Canada. The average
correlation of the fifteen major foreign country markets with the U.S. is about 0.35,
indicating potential for a significant diversification benefit. Some have opined, however,
that the correlations between global equity markets have been increasing recently. This
view may have its origin in the belief that world equity markets are increasingly subject to
common influences, and that global economies are becoming more highly synchronized.
The results indicate, however, that it is not at all clear from empirical data that there has
been any significant secular trend in correlations. A related claim is that international
diversification is not as effective during declining markets, reducing the benefit when it
would be most advantageous. The empirical evidence indicates otherwise, that there has
not been a significant reduction in the benefits of international diversification, even during
periods when the U.S. market has declined.
Emerging markets: Including emerging markets in a global portfolio can provide
numerous opportunities to add value. Such countries represent investment opportunities
today in the same way that many now-developed markets did twenty years ago. Emerging
markets present many interesting challenges as well as opportunities to institutional
investors. There is no particular homogeneity to the emerging country markets. Long-term
correlations, both to other emerging markets and to developed ones, have been quite
varied. Differences in economic development, industry composition, and local political
factors, as well as fundamental perceptions of the sources of economic growth, have led
4
to substantial divergence in return even over long periods of time. Of course, such risks
are likely to be consistent with the investment opportunities available to thoughtful and
disciplined investors. For example, over the 1986-1995 period, the U.S. market returned
15% annually. Most of the developed markets including the Japanese market have
returned in the low to mid-teens percent per annum. A sample of ten emerging markets,
Argentina, Brazil, Chile, Greece, Korea, Malaysia, Mexico, The Philippines, Taiwan, and
Thailand, have returned an average of 35% annually over the same period, with the
highest of 45% and the lowest of 19%. The U.S. market, however, has a volatility,
measured by standard deviation, of only 14.9%. By comparison, the average volatility of
these ten emerging markets is 43%.
Currency hedging: Investment policy ideally depends on the nature of a fund’s liabilities,
funding status, institutional risk tolerance and investment objectives. Many pension plan
sponsors are likely to find that short-term portfolio risk is an important corporate concern
in the context of asset management monitoring, projecting cash flows, and overall
corporate objectives. In such cases, investment horizon, risk aversion, and other
assumptions are likely to impact hedging policy. From a purely investment perspective, a
zero hedging policy benchmark may be desirable for funds with roughly 20% or less of
non-domestic assets. If the percentage of non-domestic assets is significantly larger, a non-
zero hedge policy may be appropriate in order to reduce some of the short-term currency
risk. As a simple heuristic, a hedging benchmark of 50% of non-domestic assets may be a
useful compromise policy that balances a pension plan’s long-term investment interests
with shorter-term corporate and plan funding requirements.
Global equity asset allocation: It is of interest to many global equity investors to define an
efficient allocation among the major global equity asset classes: domestic, developed, and
emerging markets. The “index” portfolio has a 40/50/10% weighting in domestic,
developed, and emerging markets, and presents an asset allocation roughly consistent with
the current capitalization of a comprehensive global equity index. While standards are
changing rapidly, a “typical” U.S. institutional global equity portfolio might include
approximately 20% of assets in non-U.S. markets. While an efficient portfolio that is
consistent with institutional global equity mandates cannot be singularly delineated, it most
likely will have at least a 10% allocation to emerging markets.
Why Invest in Real Estate Internationally?
Can Foreign Real Estate Investment Be Successful?, by Andrew E. Baum, Real Estate
Finance, Spring 1995
Driven by the desire to enhance diversification and pursue favorable return prospects,
North American, European and Japanese institutions began to seriously consider
international real estate investment in the mid- to late 1980s. According to a recent survey
that gathered 43 responses from large institutional investors, 45% of them included
overseas property in their investment strategies and planned to maintain active overseas
5
portfolios in the future. Their current allocations average 12% of real estate assets in
overseas property, but the target weight averages 21%. According to surveys, the most
popular three reasons for international property investment are diversification, higher
yields, and lower risk. Other reasons include the globalization of the occupier markets
(i.e., major tenants) and lack of opportunities in the local market.
The attraction of foreign real estate investing is clearly driven by one or both of two
objectives: 1) the possibility of obtaining superior risk-adjusted expected returns by
making opportune investments; and 2) the potential to reduce portfolio risk by
diversification.
Consider first the opportune investment motivation. Virtually by definition, this objective
envisions taking advantage of some aspect of the inefficiency of the functioning of local
real estate markets in the target country. Well-advised foreign investors should look for
two factors in particular to ferret out such opportunities: perspective and liquidity.
Contrary to accepted belief, a foreign investor can actually have an information advantage
over the local domestic market participants, in that the foreign investor may possess a
broader perspective. While local players will always have superior information about local
property and rental market conditions, exposure to the world asset markets can give the
foreign investor a unique perspective from which to view the relative investment value of
local assets.
Mismatches in liquidity around the world can cause booms and slumps, and occasionally
cheap and expensive markets, often at different times in different places. The global player
free of the capital supply constraint imposed by the local liquidity shortage, and with a
wider choice of target markets, can time transactions more effectively than the local
investor.
The diversification argument is easy to make for overseas real estate. There is abundant
evidence to suggest low correlations between global real estate markets.
In addition to the theoretical attractions of international real estate investing, the foreign
investor also faces some unique challenges and problems. The perspective advantage,
which can help foreign investors relative to their local counterparts, may be counteracted
by information disadvantages at the local level. This problem is not unfamiliar to
institutional investors. According to a recent survey, 81% of respondents say lack of local
expertise is the major problem affecting international real estate investment. Other
problems involve identifying and managing overseas properties, cultural, legal and tax
hurdles. A strong local partner may help alleviate these problems. Good research
information and appropriate investment vehicles can help minimize information risks and
specific risks.
6
Additional References
The John Dillinger Approach, by Karen Stearns, The Institutional Real Estate Letter, May
1996
• Someone once asked John Dillinger, “Why do you rob banks?” The gangster smoothly
relied, “Because that’s where the money is.” While making the initial foray into any
new market or investment climate can be frightening, investment in Asia carries with it
an enormous carrot – that of outstanding returns and tremendous potential.
• Besides the economic/performance/market cycle risks faced by real estate investors in
the U.S., Asia brings with it additional risks unique to a foreign emerging market.
These risks include political, currency, tax, legal, and overbuilding.
Going Global, by Kenn Stearns, The Institutional Real Estate Letter, October 1994
• Superior yields and diversification are the two reasons cited most often by domestic
pension funds that invest in international products.
• In general, one can’t expect to increase yield without assuming more risk. In
international investing, there are at least four: political risk; exchange rate risk;
taxation; and lack of local market knowledge.
Overseas Property Investments: How Are They Perceived by the Institutional Investor?,
by Elaine M. Worzala, Journal of Property Valuation and Investment, V12, No.3, 1994
International Real Estate: Low Correlation and Diverse Return Opportunities
Does International Diversification Work Better for Real Estate than for Stocks and
Bonds?, by Piet M.A. Eichholtz, Financial Analysts Journal, January/February 1996
The past decade has seen a surge in international equity and fixed-income investments, but
most real estate investors still stick to their own countries. An international investment
strategy also works for real estate. In fact, international diversification is more effective in
reducing the risk of real estate portfolios than of common stock and bond portfolios. Tests
of international correlation matrixes of real estate returns, common stock returns, and
bond returns indicate significantly lower correlations between national real estate returns
than between common stock or bond returns.
The data used in the study are time series of property share, common stock, and bond
index returns. The property share indexes maintained by The Limburg Institute of
Financial Economics represent real estate returns. Only total country indexes of some of
the more important markets are examined. These countries are France, the Netherlands,
Sweden, the United Kingdom, Hong Kong, Japan, Singapore, Canada, and the United
States. The study period is for January 1985 to August 1994. Property indexes are
compared with Morgan Stanley Capital International’s common stock indexes and with
Salomon Brothers’ bond performance indexes.
7
The correlations between the property share indexes in the various countries are, on
average, lower than those between the common stock and between the bond indexes.
Each property share correlation is lower than its corresponding stock correlation, and with
only one exception, this is also the case for property share and bond correlations. The real
estate securities’ correlations range from 0.07 to 0.53, the stock correlations vary between
0.24 and 0.79, and the bond correlations are between 0.19 and 0.76.
Statistical tests performed on the data reject the hypothesis that international correlations
of property share returns equal those of common stocks and those of bonds. These
findings suggest that international property share investments reduce portfolio risk better
than international common stock and international bond investments. In other words,
international diversification is more effective for real estate securities portfolios.
Real estate securities delivered returns as high as 33.4% per annum in Hong Kong and as
low as 2.2% per annum in the Netherlands (see Exhibit 1 below).
Exhibit 1. Real Estate Securities Return
Annual Return: 1985-94
Hong Kong 33.4
Singapore 21.2
Japan 12.5
United States 12.3
United Kingdom 9.9
France 8.6
Sweden 3.4
Netherlands 2.2
Source: Calculated from Eichholtz’s data
Commercial Real Estate Prices and Stock Market Returns: An International Analysis, by
Daniel C. Quan and Sheridan Titman, Financial Analysts Journal, May/June 1997
The increasing presence of real estate and foreign stocks in the portfolios of institutions
may have been motivated in part by academic studies that suggest that covariance between
U.S. stocks and foreign stocks and U.S. stocks and commercial real estate are quite low.
Thus foreign stocks and real estate should provide diversification to portfolios invested
primarily in U.S. stocks. Overseas investment may also be motivated by the search for
high yields or high capital appreciation. Exhibit 2 shows price appreciation of commercial
real estate for the seventeen markets over 1988-1994. The Asian markets have performed
exceptionally at the same time when most of the developed markets were experiencing a
real estate recession.
8
Exhibit 2. Annual Price Change of Real Estate: 1988-1994
Local Currency U.S. Dollar
Indonesia 30.0 24.7
Hong Kong 25.9 26.0
Taiwan 19.7 22.0
Malaysia 15.7 14.2
Singapore 13.2 17.9
Italy 7.5 5.9
Germany 4.7 6.0
The Netherlands 3.2 4.5
Belgium 2.7 5.3
Spain 0.5 0.7
France -0.4 0.5
Australia -2.4 0.3
United Kingdom -3.8 -4.8
Canada -4.6 -4.6
New Zealand -5.6 -5.0
United States -8.4 -8.4
Japan -9.4 -5.7
Source: Quan and Titman
Exhibit 3 shows correlations of U.S. real estate capital returns with foreign real estate
capital returns over 1987-94. All correlations are calculated using local currency returns,
so that the correlations are not the result of exchange rate changes. The correlations range
from -0.9 for Hong Kong to +0.9 for the United Kingdom. The average correlation is
only 0.11, indicating significant diversification potential of international real estate
investing.
Exhibit 3. U.S. Foreign Real Estate Capital Return Correlations: 1987-94
Correlation with the U.S.
Hong Kong -0.91
Malaysia -0.73
Singapore -0.57
Indonesia -0.53
Germany -0.38
Taiwan -0.27
Italy -0.18
The Netherlands -0.16
Belgium 0.07
France 0.46
Spain 0.60
New Zealand 0.84
Canada 0.85
Australia 0.85
Japan 0.87
United Kingdom 0.92
Average 0.11
Source: Quan and Titman
9
The database used to calculate returns and correlations consists of indexes of prime office
market properties for cities in seventeen countries. The countries (cities) are Australia (all-
cities index), Belgium (Brussels), Canada (all-cities index), France (Paris), Germany
(Dusseldorf, Frankfurt, Hamburg, Munich), Hong Kong (Hong Kong), Indonesia (Jakarta,
Italy (Milan), Japan (Tokyo), Malaysia (Kuala Lumpur), the Netherlands (Amsterdam),
New Zealand (Auckland), Spain (Madrid), Singapore (Singapore), Taiwan (Taipei), the
United Kingdom (London), and the United States (all-cities index).
Additional References
The Effect of International Real Estate Securities on Portfolio Diversification, by Jacques
N. Gordon, Todd A. Canter, James R. Webb, working paper presented at the 1997
American Real Estate Society Annual Meeting
International Diversification of Property Stock – A Singaporean Investor’s Viewpoint, by
Kwame Addae-Dapaah and Choo Boon Kion, Real Estate Finance, Fall 1996
Diversification Potential from Real Estate Companies in Emerging Capital Markets, by
Christopher B. Barry, Mauricio Rodriguez, and Joseph B. Lipscomb, The Journal of Real
Estate Portfolio Management, V2, No.2, 1996
An Examination of International Real Estate Equity Markets, by Steven Laposa, working
paper presented at the 1996 American Real Estate Society Annual Meeting.
The Home Country Bias
Why Do Pension and Insurance Portfolios Hold So Few International Assets?, by Mark
W. Griffin, The Journal of Portfolio Management, Summer 1997
Investors seem to bias their investments towards the domestic country, despite the
prospects for significant gains by diversifying internationally. This phenomenon has come
to be known as the home country bias.
Institutional investors, pension funds and insurance companies alike, hold portfolios that
appear to defy the modern portfolio theory. The most prominent characteristic of an
average, U.S.-based insurance company or pension fund portfolio is the high
concentration of domestic securities. For example, international bonds represent only
0.5% of the average insurance company’s bond portfolio and 4.6% of the average
pension fund’s bond portfolio; international equity accounts for only 3.0% and 15.8%,
respectively, of the average insurance company and pension fund’s equity portfolios. The
foreign components of the portfolios are too small relative to the composition of the
investment universe and to the allocations suggested by modern portfolio theory. In order
to justify the home country bias, the excess returns of the U.S. securities over international
ones would have to be extremely high.
10
There are several explanations for the home country bias. One possibility is that investors
desire to hedge inflation at home. A second hypothesis is that prevailing institutional
barriers to foreign investment are sufficiently large to explain the bias. A third hypothesis
is that transaction costs for investing abroad and taxes on income from foreign assets
might also be a reason for the bias. However, it is unlikely that these three factors are
sufficiently strong to account for the bias observed empirically in portfolios.
This article adds a fourth hypothesis to explain the home country bias. If the risk of an
asset allocation is measured relative to liabilities, a domestic concentration within equities
is warranted, with even a higher domestic concentration of bonds warranted. This result
depends to some extent on the length of the liabilities, with longer liabilities leading to a
higher domestic concentration than shorter liabilities. The rational is that domestic security
returns are more highly correlated with liability changes than international returns, thus
ensuring higher allocations.
Additional References
Home Bias in Equity Portfolios, Inflation Hedging, and International Capital Market
Equilibrium, by Ian Cooper and Evi Kaplanis, Review of Financial Studies, Spring 1994
Country Risk Assessment
Political Risk, Economic Risk, and Financial Risk, by Claude B. Erb, Campell R. Harvey,
and Tadas E. Viskanta, Financial Analysts Journal, November/December 1996
Given the increasingly global nature of investment portfolios, an understanding of country
risk, which is linked to expected return, is very important. This article provides sources of
this risk information and examines the economic content of five specific measures of
country risk (four from the International Country Risk Guide’s political, financial,
economic, and composite risk indexes and one from Institutional Investor’s country credit
rating). The results suggest that country risk measures are correlated with future equity
returns. In addition, such measures are highly correlated with equity valuation measures.
Many services measure country risk including:
Bank of America World Information Services,
Business Environment Risk Intelligence,
Control Risks Information Services,
Economist Intelligence Unit,
Euromoney,
Institutional Investor,
Standard and Poor’s Rating Group,
Political Risk Services: International Country Risk Guide,
Political Risk Services: Coplin-O’Leary Rating System, and
Moody’s Investors Service.
11
Each of the index or rating providers must amalgamate a range of qualitative and
quantitative information into a single index or rating. Institutional Investor and
International Country Risk Guide are two of the foremost providers of risk ratings.
Institutional Investor country credit rating takes into consideration critical risk factors
such as debt service, political outlook, economic outlook, financial reserve/currency
account, trade balance, foreign direct investment, fiscal policy, inflow of portfolio
investments, access to capital markets, etc. International Country Risk Guide compiles
data on a variety of political, financial, and economic risk factors to calculate risk indexes
for each of these categories as well as a composite risk index. Five financial, 6 economic,
and 13 political factors are used. The critical financial factors are: loan default or
unfavorable loan restructuring, delayed payment of supplier’s credits, repudiation of
contracts by governments, losses from exchange controls, and expropriation of private
investments. Inflation, debt service, international liquidity, foreign trade collection
experience, current account balance, and parallel foreign exchange rate market indicators
are the six critical factors for the economic risk rating. Some of the political risk factors
are: economic expectations versus reality, economic planning failures, political leadership,
external conflict, and corruption in government.
Do risk indexes contain information about future expected returns? Two analyses are
conducted to answer the question. First, a portfolio of countries that experienced a
decrease in risk rating (becoming more risky) and a portfolio of countries that experienced
an increase in risk rating (becoming less risky) are formed. These risk measures contain
meaningful information because excess returns can be earned by forming arbitrage
portfolios. Supplemental time-series/cross-sectional regressions are run to measure the
amount of information contained in each metric. The financial risk measure contains the
most information about future expected returns and the political risk measure contains the
least. In addition, country risk indexes are highly correlated with the fundamental
attributes of a market such as price to earnings and book to price ratios. Thus securities
markets reflect country risk levels: riskier countries are expected to provide higher returns.
Demographics and International Investments, by Claude B. Erb, Campbell R. Harvey,
and Tadas E. Viskanta, Financial Analysts Journal, July/August 1997
Demographics data contain information about the risks and expected returns of
international markets.
An example is the United States, for which lengthy time series of data exist for the
financial markets and for population trends. Time-series correlations between each age
weight (ratio of population in an age group to total population) and U.S. real equity
returns are calculated. The highest correlations are found for the 28- to 46-year old range.
That is, an increase in the proportion of the population in this age range affects equity
returns positively. This range includes the prime working age, which is likely to be the
most productive.
12
Indeed, demographics influence the prices of many real and financial assets. However, the
linkage between demographics and capital markets is more difficult to identify in an
international framework. Aside from the issues of market integration, countries with the
highest average-age increase are generally those with the lowest average age; that is,
countries with relatively young populations seem to age more rapidly than those with
relatively old populations. Aging in a global context does not simply mean that more
people are retired; it could mean, for example, that people do not die, on average, during
middle age.
An example is the United States, for which lengthy time series of data exist for the
financial markets and for population trends. Time-series correlations between each age
weight (ratio of population in an age group to total population) and U.S. real equity
returns are calculated. The highest correlations are found for the 28- to 46-year old range.
That is, an increase in the proportion of the population in this age range affects equity
returns positively. This range includes the prime working age, which is likely to be the
most productive.
Indeed, demographics influence the prices of many real and financial assets. However, the
linkage between demographics and capital markets is more difficult to identify in an
international framework. Aside from the issues of market integration, countries with the
highest average-age increase are generally those with the lowest average age; that is,
countries with relatively young populations seem to age more rapidly than those with
relatively old populations. Aging in a global context does not simply mean that more
people are retired; it could mean, for example, that people do not die, on average, during
middle age.
The evidence suggests that the demographic attributes such as average age and life
expectancy contain some information about future expected returns. Give that the
demographics variables are slow moving and highly persistent, it makes little sense that
they can be used to forecast short-horizon returns. Instead, these variables are found to
contain information about long-horizon returns.
In addition, the analysis suggests a significant relationship between the demographic
variables and a number of risk measures used in the practice of country risk analysis. For
example, 61 percent of the cross-sectional variation in 45 countries’ political risk ratings
can be accounted for by the rate of average-age increases. This finding supports the
contention that demographic data reveal information about risk exposure in an
international context.
13
Additional References
Risk and Real Estate Investment: An International Perspective, by Tom G. Geurts and
Austin Jaffe, The Journal of Real Estate Research, V 11, No.2, 1996
Political Risk in Emerging and Developed Markets, by Robin L. Diamonte, John M Liew,
and Ross L. Stevens, Financial Analysts Journal, May/June 1996
Country Risk and Global Equity Selection, by Claude B. Erb, Campbell R. Harvey, and
Tadas E. Viskanta, The Journal of Portfolio Management, Winter 1995
Currency Hedge
The Currency Hedging Decision: A Search for Synthesis in Asset Allocation, by Gary L.
Gastineau, Financial Analysts Journal, May/June 1995
One of the most important papers in the currency-hedging debate is by Andre Perold and
Evan Shulman (The Free Lunch in Currency Hedging: Implication for Investment Policy
and Performance Standards, Financial Analysts Journal, May/June 1988). This paper
argued that, from a long-term perspective, currency should be viewed as an asset with
zero expected return. Thus, any exposure to currencies other than the investor’s home
currency should be viewed as an active investment decision. Perold and Shulman conclude
that, even if the expected return is zero, the currency asset is likely to be part of a
diversified portfolio. Therefore, the basis for evaluating manager performance should be a
currency-hedged portfolio. Even those who consider the Perold and Shulman zero
expected return premise an oversimplification and who disagree with their conclusion,
generally accept the notion that an appropriate performance benchmark is a currency-
hedged portfolio.
At the other extreme of the currency-hedging debate is the work of Kenneth Froot
(Currency Hedging over Long Horizons, working paper 4355, National Bureau of
Economic Research). Based on studies covering a 200-year period, with special attention
to the past 20 years, Froot argues that real returns from currencies are mean reverting.
Froot’s calculations show that the value of hedging virtually disappears by the end of an
eight-year period. He argues that unless short-term currency effects are of critical concern,
investors are better off without currency hedging because hedging will add costs in the
long term. This argument may overlook one of the risk-reduction/return-enhancement
advantages of currency diversification management.
Perold and Shulman at one end and Froot at the other are widely cited advocates of the
extremes of currency-hedging policy. The giant, roaming the middle range, is Fisher Black
(Universal Hedging: Optimizing Currency Risk and Reward in International Portfolios,
Financial Analysts Journal, July/August 1989). For reasons based on the characteristics of
percentage relationships among asset and currency returns, and most importantly on the
structure of the global capital asset pricing model, Black argues for the existence of a
14
single, universal currency-hedge ratio that should be applied to all cross-border positions
in the absence of specific information and conviction to the contrary. Setting aside the
highly restrictive assumptions on which the universal hedge calculation is based, the value
of the universal hedge ratio is a function of several unstable observed variables. As a
consequence, the value of the hedge ratio can vary considerably over time. In examples
Black provides the appropriate ratio ranges from a low of 0.30 to a high of 0.77.
The universal hedging ratio is too unstable to be useful, but a simple 50 percent hedged/50
percent unhedged benchmark is an improvement over either fully hedged or unhedged
benchmarks because it calls attention to the potential gains from well-considered currency
allocations. This halfway benchmark helps emphasize that an active manager would not
ignore stock or bond allocations and should not ignore currencies. Based on the mechanics
behind Black’s argument, the 50/50 benchmark is not a bad policy for a passive manager
and it is a reasonable starting point for an active currency manager.
In the United States, currency-hedged benchmarks are the accepted norm, but the AIMR
performance presentation standards allow for alternative currency benchmarks if an
investor and a manager want to use them. Many investors and their managers have agreed
on a 50 percent hedged/50 percent unhedged benchmark or on an unhedged benchmark.
Additional References
Currency Swaps for Hedging a Realistic International Real Estate Investment: Do They
Work?, by Richard D. Johnson, Elaine M. Worzala, and Colin M. Lizieri, working paper
presented at the 1997 American Real Estate Society Annual Meeting
Asset Allocation with Hedged and Unhedged Foreign Assets, by Jorion Philippe, Journal
of Portfolio Management, Summer 1989
Emerging Real Estate Markets: A Case Study for China
Latent Demand for Urban Housing in the People’s Republic of China, by Jeffrey S. Zax,
working paper, University of Colorado at Boulder, 1997
This paper explores the differences in family characteristics and dwelling size between
those who reside in state-owned and those in own-built housing in China. State-owned
dwellings are allocated by the state. Own-built housing is allocated by free markets. The
mechanism that assigns state-owned housing to urban families produces a very different
match between family characteristics and housing space than does a mechanism based on
optimizing expressions of family housing demand. The dwellings that families want are
much larger than bureaucrats think they should have. For example, sample families in
state-owned dwellings have an average total space of 39 square meters and those with
similar characteristics in own-built dwellings would like to have 68 square meters.
Data were collected from a survey of 9,009 urban families in China. Using this data a
special type of regression is run to determine the propensity to choose own-built rather
15
than state-owned housing. Regression equations also determine the size of dwelling a
family would require based on characteristic explanatory variables such as employment
types and incomes.
The demand for own-built housing in China is growing. This will open many
opportunities for investment in areas such as housing development. Because the demand
would be for larger domiciles, continued reform would generate a strong demand in terms
of housing units and space.
Benchmark Pricing Behavior of Land in China’s Reforms, by Ling Hin Li and Anthony
Walker, Journal of Property Research, 1996, pp.183-196
Following the open door policy, China is allowing a major and valuable national resource,
namely land, to be privatized in the market. Land has not been allocated according to the
market since the Communist Party took power in 1949. Without extensive market
activities it has become imperative for both central and local governments to devise
guidelines when selling land to developers who have found great potential in this market.
After initial pilot studies in some cities, a benchmark pricing model was finally devised to
provide guideline land prices.
The benchmark price is the average price level established within a specific time period in
a particular area/locality for a particular land use. It is set by the government land
management departments and the state valuation committee according to transaction data
as well as expected revenue from land.
To turn benchmark prices from being a baseline reference into a more representative
measure of the actual market means, more frequent updates of the benchmark price tables
are needed. This is not easy given the lack of a relatively efficient real estate market in
China. The observed divergence in land prices achieved under different land sale
procedures reflects the immaturity and inefficiency of the market.
This paper is particularly relevant to developers because it details the historical and current
land valuation policies in China and their deficiencies.
Spatial Trends of Urban Development in China, by M. Atef Sharkawy, Xiangqun Chen,
and Frederik Pretorius, Journal of Real Estate Literature, 1995, pp. 47-59
Urbanization and its spatial distribution have witnessed dramatic shifts since China
adopted its open door policy in 1978. Based on statistical analysis, this study suggests that
foreign investment and rural enterprise formation are the most significant variables
affecting urban development in China. Using a geographic information system, this
research finds that spatial distribution of development follows a historic pattern: along the
coastal zone, intensified in deltas and extending inland along rivers. The pattern of
development was initially concentrated in special economic zones, economic development
zones, and priority development areas which serve as industrial export platforms such as
16
Guangdong and Hainan serving Hong Kong, and Fujian and Zhejiang serving Taiwan. The
industrial sector soon helped the agricultural and trade/retail sectors and was then joined
by an active public and private service sector.
This study concludes by projecting the distribution of the most likely future development
in China. Intensive urbanization and development in the future will be concentrated in
three areas. First, the current intensive development areas in Hainan and the Guangzhou-
Hong Kong area will move inward to the Pearl River Delta. Second, Shanghai will lead
the Yangtze River Delta into rapid urbanization. Third, the Beijing-Tianjin area will lead
its neighbors to a higher development intensity.
Implications of China’s New Property Law on Real Estate Investments, by Lim Lan Yuan,
Real Estate Finance, Fall 1995
In 1994, the Chinese government introduced the latest legislation on real estate: The Law
of the People’s Republic of China on Urban Real Property Administration. It took effect
on January 1, 1995. This law is designed to systematically regulate the whole range of real
estate activities in the country: buying, selling, leasing, mortgage, and development. The
new law sets out the general provisions governing the granting and allocation of land-use
rights, property development, transfer of property, title registration, the mortgage and
leasing of property, and legal penalties for infringement of the law.
There are several general themes in the new law. A significant attempt has been made to
dampen property speculation and to ensure full market disclosure of all transactions. The
procedures for the granting of land-use rights and title registration have been streamlined,
and the division of the functions and powers of government departments in charge of land
administration, urban planning, and building administration has been clarified. However,
some flexibility has been reserved for the State Council to create detailed administrative
rules to resolve controversial problems and for the provisional government to formulate
working rules based on their respective local conditions.
17
Additional References
China Housing Investment, Prudential Investments research report, 1997
Asia, Urban Land Supplement, May 1997. In particular, Investing in Asian Pacific Real
Estate by Kenn Stearns and China: An Emerging Economic Giant by Robert H. Edelstein
Housing Rent and Occupational Rank in Beijing and Shenyang, People’s Republic of
China, by Yanxiang Anthony Gu and Peter F. Colwell, Journal of Property Research,
1997, pp. 133-143.
Privatization of the Urban Land Market in Shanghai, by Ling Hin Li, Journal of Real
Estate Literature, 1997, pp. 161-168
Land Use Rights Reform and the Real Estate Market in China, by Anthony
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Reports From Prudential Real Estate Investors Investment Research
Forecasting Office Space Demand - November 1997
China Housing Investment - November 1997
International Real Estate Investment: Digests of Research Papers from an Investor’s
Perspective - November 1997
Senior Housing: An Emerging Institutional Investment Industry - August 1997
Tracking a Capital Market Transformation: Public Market Commercial Real Estate
Penetration - August 1997
The Evolution of Public and Private Market Investing in the New Real Estate Capital
Markets - June 1997
The Change in Prudential’s General Account Real Estate Investment Strategy: Is It
Appropriate for Pension Fund Investors? June 1997
“Development and Implementation of an Integrated Portfolio Management Paradigm” -
Spring 1997 (reprint from Real Estate Finance)
Housing: Strength and Resilience - March 1997
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Prudential Real Estate Investors, 1997 all rights reserved.
8 Campus Drive, Parsippany, NJ 07054
Information contained herein is based on data obtained from recognized statistical
services, issuer reports or communications, or other sources, believed to be reliable.
However, such information has not been verified by us, and we do not make any
representations as to its accuracy or completeness. Any statements nonfactual in nature
constitute current opinions, which are subject to change.
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