30/10/06 - Why Buy International Real Estate?

"Why international?" has become an increasingly familiar question asked by real estate investors in recent years. Traditionally, investors have justified allocations to international real estate with arguments based on either enhancing return or diversification. Both arguments are valid, of course. In fact, although debates over the merits of investing internationally often presume that the potential diversification and return enhancement benefits are somehow mutually exclusive, both can be realized with a carefully developed and executed investment strategy.

Still, for investors in the United States who have a wealth of opportunities available in their domestic market, the decision to invest overseas is more discretionary than it is for many of their foreign counterparts, particularly those investors whose domestic markets are too small to accommodate their desired real estate exposure. However, changes in the global marketplace over the past decade suggest that the opportunity costs associated with not investing internationally have increased. Today, at least three compelling arguments exist-prudence, diversification, and diverse opportunities-that suggest that U.S. investors should take a different approach when deciding whether or not to invest overseas.

Perhaps the most obvious answer to the question "Why international?" is the size and distribution of the commercial real estate universe. The U.S. is a large and diverse market, but it still represents a minority share of the global investable universe of commercial real estate.

Since 1990, the U.S. GDP share relative to the world total hovered between 25% and 32.5% (see Exhibit 1). Due to the dollar's recent weakness, the current U.S. GDP share is about 27.7%. Over the longer term, the U.S. economy will likely command a trend share of 30%. As of 2005, the top-down estimate of the U.S. share of global investable real estate ranges from 32.7% to 37.7%, with a midpoint of 35.2%.1 Since 1990, the U.S. real estate share has been as low as 32.5% and as high as 40.0%-all mid-point estimates. The U.S. commercial real estate market will likely claim a world share of 35% to 40%-the 5% differential represents the uncertainty in the estimate itself.

With almost two-thirds of the investable real estate universe located outside of the U.S., it seems fairly obvious that the set of opportunities available to global investors is significantly larger and more diverse than that available to U.S. investors who "stay home." The wealth of opportunities outside the U.S. is not a new development. With the possible exception of Asia, which likely gained share due to Japan's booming real estate market in the 1980s, the distribution of real estate assets has probably changed relatively little since the early 1970s.

What has changed, however, is the accessibility of markets all over the world with the development of investment infrastructure and vehicles that simply did not exist twenty or even ten years ago. As recently as the late 1990s, for example, foreign investors could not invest directly in South Korea. Today, the market is readily accessible and has experienced significant foreign capital inflows.

To be sure, meaningful information costs are still associated with investing in real estate overseas. Taxes and currency risks need to be weighed. Legal systems and leasing terms and practices differ. Even language barriers and time zones are potential obstacles. However, given the size and increasing accessibility of many foreign markets, prudence alone dictates that U.S. investors should at least consider some exposure to international real estate.

Investors who choose to invest overseas must first consider the size of the allocation. Although the U.S. market represents about one-third of the investable universe, it would not be appropriate for a U.S. investor to allocate two-thirds of the real estate portfolio to international investments. The wealth of opportunities in the U.S., structural imperfections in many foreign markets, currency risk, and a home bias in the liabilities of U.S. institutional investors argue against such a large international exposure. To take advantage of the potential benefits of investing internationally, however, investors need a meaningful allocationotherwise, the effort and cost are not likely to be rewarded.

Intuitively, an allocation of 20% to 35% of the real estate portfolio should provide sufficient exposure for most U.S. investors to realize the benefits of investing internationally. This range is justifiable from a theoretical perspective. Exhibit 2 shows a range of possible allocations to international real estate based on different volatility and correlation assumptions.

To avoid the mentality of chasing higher returns, the allocation results shown reflect identical expected returns for both U.S. and international real estate. Under the equal-return assumption, the optimal allocation is a function of the correlation between U.S. and international real estate and the volatility ratio of international to U.S. real estate.