It Pays to Get a Grip

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The global investor and risk-taker should be part district attorney, part story teller, part psychologist, probably part book-maker, part visionary, and candid empiricist. He or she must embrace the due-diligence process, which is comparable to saying that the child must savor that spoonful of castor oil, or that second helping of steamed spinach. Not easy to see happen. Failure to do so, though, means chancing the abyss for one’s risk capital. Better to try and see what you are doing and where you are going through employing sound due diligence practice – along with attendant qualitative and quantitative tools – than to travel blindly, or worse, blithely.

During the past several months, MMD has been in discussions with an institutional investor on how to square the proverbial circle on international commercial real estate exposure. Domestic commercial real estate investing they know, but venturing outside of the US they don’t, or certainly not as well.

The gist of the problem is – they already own this problem, or rather exposure. For them, things had grown incrementally. They saw one deal where the general business characteristics looked good, so they booked it. In other instances, deal characteristics for more international opportunities were appealing, so they booked those exposures, too.

Now with an extant international commercial real estate portfolio, they began thinking more about the risks they hadn’t articulated for themselves in addition to those they were more comfortable recognizing. Was international commercial real estate investing just the same as US commercial real estate? Must there be a distinction? Was it more of a wash?

From MMD’s perspective, we thought that a “wash” might be one where no real distinctions could be made, say, between investing in the US commercial real estate market or doing so internationally, say in “country x”, for example. In such a situation, the underlying environments for the US market and for “country x” would be roughly the same: institutions would function with the same efficacy and inspire the same level of resident confidence; confidence of creditors, both domestic and external, in both countries would register roughly the same. In such a situation, the risk premium affixed to the asset class of US commercial real estate – that is, the premium that would inform the “hurdle rate” on whether an investment’s returns justified the risk being incurred – would be the same for “country x”.

That institutional investor’s own intuition and view on global market conditions steered them toward acknowledging country distinctions. The country-of-risk environment – engendered in its customs, practices and institutions – influences outcomes for the foreign lender and investor, distinguishing those outcomes from results to be had in the home market. Sometimes the effects are negligible, but sometimes they are much more relevant – so much so that those effects will determine whether or not the prospective return actually justifies the risk.

With the above in mind, MMD developed its Gross Risk International Premium or GRIP approach. So, for the sake of argument, if there is no real difference in country risk levels between the US and another country-of-risk, then the risk premiums for, say, the commercial real estate markets of those two countries would be roughly equivalent, both reflecting the risks inherent to that asset class. But, if there are “risk” differences between the two countries, then an adjusted risk premium should reflect that.

To estimate its GRIP measurement, MMD first took an industry association cited US commercial real estate risk premium spread (that is, the average spread of the benchmark US cap rate minus the US 10yr Treasury yield), then adjusted that US premium against country risk “factors”.

We gauged the confidence the creditor has in exercising a claim in the US market against the level of confidence that creditor would have with a comparable claim in the country in question. To approximate this relative standing, we take the ratio of the benchmark business default recovery posted in the US to the benchmark value estimated in the foreign country-of-risk. Benchmark business default recovery values on a country-by-country basis are found in the research produced by the World Bank. Note that a higher ratio value, implying a larger US recovery value, will entail a greater country-of-risk premium.

The second “factor” is to gauge the relative level of country risk vis-à-vis the US. Toward this estimation, we assign broadly a factor value of 1.0x for “investment grade” countries, a value of 1.2x for countries that are “marginally” investment grade in the BBB+ thru BBB- range, and a factor of 2.0x for countries that are “sub-investment grade”. Factor value assignment is determined through a “waterfall” method, where a country’s second “worst” rating is selected from three country ratings: Moody’s, S&P and MMD.

The MMD country rating is drawn from its SIRE (Solvency Institutional Resilience Estimate) model, which is a logit regression model estimating the relationship between significant country World Governance Indicator (WGI) scores (measuring country institutional quality) and country default status (that is, whether a country has defaulted on its external debt at least once over a given period). SIRE model results map to the MMD country rating scale, making the MMD ratings cross-comparable to the major rating agency ratings.

A country showing a poor country rating, that is non-investment grade, will be penalized, receiving a higher assignment factor and entailing a higher risk premium.

Importantly, the composite adjustment factor results from the multiplied product of the US/country-of-risk default recovery ratio and the assigned country ratings factor. The worse that default recovery ratio is a for a country, and the lower its country rating, the higher the composite adjustment factor will be.

The composite adjustment factor is then multiplied against the cited benchmark risk premium for US commercial real estate to arrive at the GRIP calculation. In the event where the country in question is solid investment grade and it’s estimated business default recovery value is on par with the US, the GRIP is equivalent to the US risk premium for commercial real estate investing. Arguably, the creditor on a benchmarked basis can anticipate recovering comparable value in a default situation to the value a US creditor generally receives in such a situation. A country demonstrating solid investment grade status arguably has public institutions that work comparably well to those in the US for the creditor and investor.

The GRIP is only an approximate measure but it can provide guidance as to what kind of return an investor should envisage when investing in commercial real estate in a non-US market. This use of this kind of analytic, for example, and the due-diligence process in general are necessary for the investor or lender to think ably about commitments, size exposure correctly, thereby not putting or leaving too much on the table.

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