Korean institutions have become meaningful overseas alternative investors as they bid to meet their portfolio return targets.
In the first three quarters of 2018, they committed $4.7 billion to direct global real estate investments, according to deal tracker Real Capital Analytics. Their 2017 total was higher at $9.5 billion, that figure an 8.3 percent increase from 2016.
US-focused managers, however, are benefiting from these cross-border capital flows less and less. While debating whether to invest in the US or Europe, the Korean consensus is increasingly that Europe makes better sense. The numbers substantiate the switch in appetite. RCA says Korean investors bought $2.8 billion of US property last year, significantly less than the $4.2 billion they bought the year before. Europe’s top two markets, the UK and Germany, meanwhile, received $3.5 billion from Korean institutions, up from $1.8 billion the year before.
Rising valuations leading to cap-rate compression has, predictably, been the top concern in most real estate markets around the world. But for Korea’s investors, the added headwind of a high cost of foreign exchange hedging has become a major dampener for Korean investors considering outlays stateside.
After factoring the cost of hedging their US dollar-denominated investments back into the Korean won, investors are finding it hard to find deals that meet their minimum return threshold criteria. One executive director at a Korean insurance company told Real Estate Capital‘s sister title PERE currency hedging is currently shaving off as much as 1.5-1.8 percent from its total investment returns.
The insurer, which prefers to tackle the asset class by investing in conservative debt strategies such as senior lending, said it is tricky to invest in US real estate debt because it is unable to meet its 6 percent risk charge requirement after factoring in the hedging cost. European investments, on the other hand, are currently generating a hedging premium of around 100-150 basis points.
The gap between the US and Korean interest rate has widened. The US Fed’s current benchmark rate is 2-2.25 percent, with another hike expected this month. Korea’s key interest rate is currently 1.75 percent. This has pushed up hedging costs. In April, for instance, the three-month dollar-won forward points – a measure to determine the interest rate differential between two currencies – fell to its lowest level since 2009, according to calculations by Bloomberg.
For Korean insurers, this currency headache compounds issues relating to offshore investing. The country’s financial regulator is set to implement International Financial Reporting Standards (IFRS 17) and new capital guidelines called K-Insurance Capital Standards in the coming years. They will impose minimum amounts of required capital to be held by insurance companies, much like the Solvency regulation in Europe.
As such, insurance companies will become more selective when making equity investments, or any investment with a fluctuating net asset value, and instead pursue more long-dated debt investments. When hedging costs become an added worry on top of this regulatory constraint, investing in Europe naturally becomes a better risk-adjusted strategy.
Deploying capital in the US will always have a cultural allure given its economy is seen as being among the world’s more stable. One executive at a Korean insurer told us it remains hard to preclude US investments, even despite today’s currency challenge. His firm is willing to engage the asset class via floating-rate debt products. Another executive, from a Korean retirement fund, said it revised its investment policy in January to reverse a policy requiring investments to be hedged back to the won.
But, for now, these are exceptions rather than the norm. Ultimately, it boils down to performance and American real estate, impacted by prohibitive hedging costs, is at an ebb when it comes to its property attracting Korean money.
Write to the author, Arshiya Khullar, at firstname.lastname@example.org