Protecting Foreign Real Estate against FX rate moves

Protecting Foreign Real Estate against FX rate moves is important if you own overseas property.
Protecting Foreign Real Estate against FX rate
We currently own one cash flow positive property with no mortgage in Canada, and are in process of buying a 2nd property. Basically we are looking to achieve a few things:

  1. Diversify away from US dollars (USD) using foreign currency in a stable country
  2. Get long some oil using the commodity currency Canadian dollar (CAD) as proxy. This works because crude oil and CAD are positively correlated.
  3. Get some relatively cheap real estate in a different country, to diversify away from a high cost US area where we live.

Our home currency is US dollars (USD) and the properties will be run in Canada with all local Canadian dollar (CAD) income and expenses. The plan is to take a commercial mortgage in Canadian dollars (CAD) across two houses at 50% Loan To Value (LTV). From a US dollar (USD) perspective this is essentially long / short CAD in almost equal amounts, where the house equity is “long” Canadian dollars and the mortgage is short Canadian dollars.

Obviously this still has all the usual real estate risk locally, such as local economy downturn, vacancy periods, high maintenance expenses (etc). This assume that both property will be cash flow positive (they will) and because we have a local property manager, they essentially run themselves. Again here we made sure both properties are initially cash flow positive so should be able to hold long term – we are have given enough margin of safety with 50% equity that we can safely (hopefully) assume that should not be forced to sell even if local property prices were to significantly decline. There are no planned foreign exchange (FX) conversions planned in the day to day running of the Canadian properties.

In summary the 2 properties would be exactly 50% long 50% short CAD (house equity/mortgage) with built in equity cash flow (the rent minus expenses).

Risks

Below we can see that there are a few risks to owning foreign properties. We will focus mostly on FX risk for this discussion, but it is worth highlighting the others below.

  1. FX risk. With our 2 properties if the CAD USD FX rate declines so much, we would have a paper loss in USD due to the original equity we have in the properties – even if all other factors like local house prices and monthly operations are constant.
  2. Local real estate risk. The local economy could have a significant downturn, we could have issues with vacancy periods, property may require higher than estimated maintenance expenses. These are the standard real estate risks, just that they need to managed remotely by our property manager.
  3. Pay Bid/ask spread on any FX transactions. Every time money is sent to Canada we have to pay the bid/ask spread on FX conversion. We use a currency dealer who gives decent spreads (approx 0.7%), which is not great, but significantly better than main street banks.
  4. Local company regulations to run a real estate company. There are initial company setup fees, annual province (state) filing fees to maintain a Canadian holding company to own the real estate. Need to maintain a Canadian based accountant who is familiar with Canadian tax law. There is an annual cost of holding real estate in a Canadian entity, however these pro-rota into annual property expenses and are covered by the rental income. The company does not require extra money to be added annually to cover these costs. However this require effort to ensure compliance with regulatory, legal and tax obligations for owning property in Canada – however the because it being held in full Canadian based entity paying Canadian taxes crucially . Most importantly no tax is withheld on rental income because the company is considered a Canadian resident – so there are benefits to doing the extra paperwork.
  5. Bankruptcy risk on company operations. The cash flow is not sufficient to maintain operations and/or a unforeseen event occurs that makes your real estate business operations not viable. However because this was setup inside a company structure, then this limited only to the real estate itself, not your personal finances.
  6. Sovereign country risk in Canada. Economic issues such as lower oil prices or a recession could make real estate prices decline or make it find to locate well qualified local renters. This is the same in any real estate investment, however the Canada economy is typically more tuned to commodity cycles than the US economy. Current central bank strategy between are different US and Canada – where US Federal Reserve is raising rates, while Bank of Canada is holding rates. Canada was also in a technical recession for last 2 quarters (but has lifted in latest quarter) – USA has been steady so is currently relatively more attractive. However the Nova Scotia economy is separated from the larger cities of Vancouver/Toronto/Calgary – it will be impacted by economic cycles but traditionally they don’t tend to have huge commodity boom/bust cycles. CAD is commodity funding currency, so about 80% correlated to moves in Oil. Oil prices have moved down from $110 to $40 ish. Importantly it is worth noting that currencies are also relative not absolute – even with a recession, if Canada does “better” than USA then its currency could rise versus USD. CAD USD FX Rate is not as correlated with standard equity markets, more commodities, but it has a full service based economy (essentially tied to the US economy) and its not Brazil (e.g. not just taking a punt on an emerging market currency just as a commodity play).

US v. Canada mortgages

There are some differences between Canada and US mortgage markets for primary residences and rental properties. Mortgage interest is not deductible on primary residence for an individual in Canada (as distinct from US where it is), however mortgage interest is deductible on rental properties. Although there is no capital gains tax (or gains limit) on primary residence.

Given that, some Canadians do rent their primary residence and buy rental property, rather than necessarily buy own home. Essentially this can be a viable option because of the tax code. Long term renting where you live (and buying rental property investment with the spare cash) could make more sense. Whereas in the US, the tax code is massively skewed to buying your primary residence.

Plus most Canadians banks keep mortgage loans on their books – that is they don’t securitise or resell loans straight away to other banks like they have in US. Therefore a Canadian bank is highly motivated to make sure their own underwriting is effective, because they could be carrying the loan for up to 25 years (which explains why big bank lending can be relatively cautious).

This explains the relative historical stability of the Canadian housing market. The differences between the US and Canadian mortgage market explain some of the slightly more cautious lending practices, but frankly that makes it more attractive as an investment. Canadian mortgage market is actually slightly different to the US market, but in a good way for investments.

We found commercial mortgage underwriting standards very strict, maximum they would do was 65% LTV (and they were still debating that..). Other banks would do higher LTV, but they require a significant financial deposit or savings to be with the bank before the loan would be advanced (sometimes up to 50% of actual loan size was required to be on deposit!). Local credit unions had more flexible terms underwriting terms than the big banks.

FX Rate Risk – Historical Moves

Now let us have a look at the historical moves of USD CAD FX rate to see what risk we are actually taking on. We will look at historically what was the largest FX move where Cad strengths (moves against you) on an annual basis in percent terms. For example the total percent depreciation was -24% in last 5 years (% move where start date is T-5 years and end date is today). However that is not typical and is a significant down move, however that is why the the investment opportunity exists.

Below is historically what what were annual USD CAD FX moves in percent terms since early 1990s. These have been calculated from a spreadsheet that uses average monthly prices (for each month) from Jan to Jan – it is not 1st Jan to 31st Dec – but they give an indication of expected historical annual moves.

In the following table a positive percent means USD weakens against CAD (investment makes money). A negative move means USD strengthens against CAD (investment loses money).

Year
Percent move
19901.44
1991-0.02
1992-12.05
1993-3.96
1994-9.68
19954.64
19961.58
1997-8.85
1998-8.23
19997.28
2000-5.38
2001-9.77
20025.94
200324.47
20047.19
20056.54
2006-1.71
200716.61
2008-21.68
200918.39
20104.89
2011-1.93
20122.06
2013-10.11
2014-10.5
2015-9.6
2016 (YTD)8.5

Based on this you can see that there were typically price movements in the annual range of -10% to 10% volatility, however the last 3 years have been double digit declines every year (which is unusual).

FX Rate Scenarios

This section will look at USD CAD FX rate scenarios where it stays the same, goes up or goes down (think we covered every possible angle in the investment world there!).

  1. Stays the same or goes up. If the CAD stays the same or appreciates we would probably just hold. If it appreciates very significantly it might be worth send back any cash flow in appreciated CAD into depreciating USD. This return of cash flow would act as a psuedo annual dividend. Ultimately in several years if there is significant FX rate appreciation it could be worth just selling one or both properties and converting it back to USD. It is completely possible you might make limited local real estate gains but significant FX gains due to FX rate appreciation. Importantly FX gains are not taxable, but obviously you have pay local Canadian taxes on any capital gains. The mortgage will be a greater debt in USD so you would not want to use USD to pay down the mortgage, just use local CAD cash flow for that.
  2. Goes down. If the CAD depreciated further the total real estate investment starts to lose money mark to market in USD. This is probably not a problem in local CAD currency to manage monthly operations, however it is still a mark to market loss that we might wish to reduce. Additionally with a significant move of say 10% or more we would consider paying down some mortgage principal (in CAD) with strategic annual USD to CAD transfers (as the rate is in our favour). Since a major risk to our investment is if the FX rate declines, in the next section we will look at some possible strategies to help manage that scenario. These strategies will be to pay down the mortgage or hedge the FX rate.

FX Rates risk management – hedge FX rate

The main question we have to ask is, do we technically even need to hedge with a 50% / 50% split of mortgage / equity all based in CAD currency?

The mortgage is in CAD and we are amortized principal payments in CAD. So on one hand we are long 50% in CAD exposure due to the real estate value (at 50% LTV). But on the other hand if you are taking a loan in CAD, you are short 50% CAD because you benefit from the USD strengthening. The exact 50% / 50% split of an asset in CAD vs liability in CAD, gives a built in natural hedge.

Also if we are going to hedge how aggressively should it be done ? There is a fair amount of equity (long CAD) position in the real estate, however as an investor it is better to take a view and hedge less. There is no value in hedging away all the risk to invalidate the actual investment idea.

It is possible to use /6C Canadian dollar futures put options to “disaster hedge” the FX rate. We are already holding a 5% OTM put 6 months or 1 year out for contracts of /6C, hedging at about a 0.25 delta on average. These are then rolled up or down after a few months as necessary as the FX rate moves. Additionally it is then possible to sell OTM call spreads against FX rate for income, to slightly offset the cost every month. If FX rate declined 10% would probably recycle that money into CAD mortgage and re-hedge. As long as keep long term OTM hedges in place this can be relatively cheap less than 1.5% a year of total investment – and that assumes zero gains from short call spreads which is not likely if rate declined. This is managed in a trading account along with other spreads (eg Long gold, short oil etc). Ideally it would just lose a small amount of money each year (which other spread can make up for) which is what happened so far this year. Fundamentally we would see this real estate investment as a married put strategy (long 2 houses in CAD, with long contracts on /6C futures put) on a dividend paying stock (small monthly rental cash flow profit plus paying down mortgage).

If rate went down 20% in a year you would lose money mark to market, but it would probably lose only say max 5% to 10% in a year (depending on option rolls). This assumes no other variables change, and assuming no gains from overlay trades and ignoring mortgage paid down which is about 1.25% of principal risked in first year. But point is that now the investment is not undefined FX risk. Any profit on hedges could either kept as cash or Fx back over to pay mortgage.

The issues are that it costs some money to hedge, but we are used to managing it as a trading account anyway. Leverage on those options is very good in a rate crash scenario. There are also cheaper / limited risk reward ways to keep short delta eg put calendar and ATM call spreads. As long as the “disaster hedge” with the 3 contract /6C put is always in place (in case the floor falls out again) should be ok. For example, when FX rate crashed in Jan 2016 that put option made significant USD dollar amount. Hedges are based in a USD trading account.

Ultimately in several years time you have 2 houses and lower mortgage principal, so over time your FX risk (CAD principal) increases so might have to increase hedging size later on.

FX risk management – pay down mortgage

If rate goes down 10% against CAD, the mortgage can be paid back with more valuable USD dollars. Any significant mortgage principal reductions early in the lifetime of a mortgage can have reduce the ultimate pay back time.
Therefore it would seem sensible to do a small principal payment (say between 1% to 10%) each year to reduce the mortgage if the FX rate is consistently in your favour.

However don’t want to pay down too much of mortgage, because you are increasing your long exposure to CAD each time you do that. Effectively you might be removing your hedge against a depreciating currency when you might need it most.

Conclusion

Even if the CAD currency is beaten up due to a lower oil price, Nova Scotia is a relatively diversified local economy on multiple sectors (not heavily oil related like some western Canada economies). Historically steady not commodity boom and bust (even in 2009). Also real estate is reasonably priced even in local currency, and it’s a buyers market there. Don’t need to make a killing in local landlord market, just need to keep lights on. Worse case mortgage is paid back in 25 years (typically commercial mortgage length in Canada) not 30 years like US residential mortgage. Plus ultimately own 2 houses at the end of the investment, which should more than match any FX move.

We decide to hedge, but keep it light. Hedging is an art no right or wrong answer. Since basically we were looking to diversify a bit from USD, want to get long some oil (via CAD) and own local real estate it is a good transaction. We only hedged approximately half our exposure, so if there is a strong oil rally you win on the original investment idea, and don’t lose too much hedging. Also if the FX rate moves significantly against us then the hedging will help and we could pay down the mortgage more. There is “no free lunch” (is there ever?) but the risks can be managed, and a significant move in the FX rate in either direction can still hopefully be managed to our advantage.

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