Prior to close
The uncertain close of a real estate transaction creates unique requirements for FX hedging. The hedge must incorporate degrees of optionality, so that as a deal moves through the due diligence and lending processes, and the likelihood of closing increases, hedging vehicles must match the level of certainty. Deal-contingent forwards are one such tool, as they allow hedging their equity against inevitable currency fluctuations without the risk of having to bear mark-to-market losses if the deal falls through. Other tools include options with cancellable features such as American Cancellable cliquet options, contingent premium options, and compound options.
CRM analyzes the deal acquisition structure and probable timeline, and helps select the optimum pre-close hedging vehicles. Pricing of contingent trade derivatives is often quite opaque, and CRM will also help negotiate favorable terms.
Development / Holding Period
The development and holding period exposure is characterized by debt service (usually denominated in the local currency for natural hedging purposes), and rents or partial sales in local currency. Depending on the investment company strategy, the local currency income stream may be repatriated, used for debt service and/or paydown, or retained in-country for other purposes. Often, hedging these cash flows can be combined with hedging of the exit strategy.
Exit / Sale
Hedging the eventual sale of the investment is challenging mainly because of its long tenor, typically 3-7 years, and uncertain terminal value. Hedging FX over such long periods precludes the use of most hedging vehicles such as forwards and options because of cost or availability (most banks will not write options or forwards for longer than 2 years.) One tool which does work well is the cross-currency swap (XCCY). This is an agreement to exchange interest payments and principal denominated in two different currencies. The net effect is similar to a forward, except that instead of adjusting the forward rate to accommodate different interest rates, the terminal principal swap is executed at the same spot as at inception, and periodic interest rate payments are exchanged during the tenor. As the illustration at right shows, an XCCY can protect against adverse currency moves during any length of holding period, and numerous studies and simulations confirm this.
There is considerable variation in XCCY structures (fixed vs. fixed, fixed vs. floating, pay/receive frequency, basis), and selection needs to take into account the investment strategy (debt service/retirement, timing of fund repatriation) and other risk (basis, sovereign, counterparty) etc.
CRM can help investors structure an XCCY which best matches the particular investment strategy and capital flows, while minimizing risk.