By Jim Costello on October 8th, 2020
German investors have new incentives to look at commercial real estate investments in the U.S. This group of investors was the second largest source of cross-border capital for deals in the U.S. over the last 12 months, behind Canadian players. A short while ago it was difficult for German investors to look at U.S. because of hedging costs. Those costs are fading and can make U.S. investments look comparatively inexpensive.
From 2017 until recently the yields on offer for assets in the U.S. provided little benefit for German investors. These players would traditionally focus on deals involving high profile properties in the 6 Major Metros of the U.S. Some German investors continued purchasing assets in the U.S. for a time, with more of a focus on higher-yielding deals in U.S. secondary markets, but even that activity pulled back because of broader financial considerations.
High interest rates in the U.S. and low rates in Germany and the euro area made the cost to hedge U.S. investments ruinous for German investors. Looking at the difference between short-term interest rates approximates the cost of a currency hedge, and at the end of 2018 the spread between the 1-month Euribor and 1-month USD Libor hit a high of 287 basis points.
The way to think about that cost of a currency hedge for German investors is that, they had to find an extra 287 basis points somewhere in a U.S. deal to hit their target returns. That cost to hedge drove relative pricing of U.S. assets to often unobtainable levels for these investors.
Looking at cap rates for office properties in the U.S. 6 Major Metros versus those for the German A Cities, it is clear that for a time, these office investments simply looked too expensive relative to deals at home. One can roll that cost to hedge right into cap rates by subtracting out the cost to hedge from the cap rates.
In late 2018, for instance, while office cap rates in the 6 Major Metros had been stable just above 5% since 2015, the hedge-adjusted cap rate fell below 2.5%. German investors pursuing office deals at such cap rates would have had to make heroic assumptions about future income growth to hit their targeted returns.
Cap rates for office properties in the 6 Major Metros are now higher than those in the German A Cities, both in nominal terms and adjusted for the cost to hedge currency risks. As economic growth has slipped in the U.S., so too have rates on the short end of the yield curve, reducing the cost to hedge currency risks. As this financial barrier fades, German investors can once again focus on deals in the U.S. Still, the risks to economic growth in the U.S. brought on by Covid-19 are concerning for all investors and may make 5% still look too low.
Mike Savino provided data analysis for this article.
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