A hybrid facility, blending a basket of local and hard currency with a bank hedge, provides an alternative to managing currency volatility and liquidity risk in African commercial property transactions.
US dollar yield accounts for much of the attraction of investing in African commercial property. A US dollar-yielding commercial property investment, ideally needs to be funded with a US dollar denominated debt instrument.
“Since commercial real estate in Africa typically generates earnings in local currency even though it is indexed to the US dollar, risk arises when the local currency depreciates against the US dollar,” says Wicus Badenhorst, Head of Real Estate Finance for South and Central Africa, at Standard Bank.
African currencies are currently in protracted devaluation against the US dollar. In this environment, African commercial property funds are increasingly running into US dollar-driven volatility and liquidity challenges as local currency earnings devalue against US dollar-denominated debt.
As the US dollar continues to appreciate against African currencies there is likely to be downward pressure on rentals as more local currency is needed to generate the US dollars required to service hard-currency denominated lease obligations. Either that, “or vacancies will increase as tenants can no longer afford to fund the growing difference between local currency earnings and US dollar lease obligations,” cautions Mr Badenhorst.
Added to this, “investors’ ability to convert local currency rentals into hard-currency is becoming increasingly strained as hard-currency liquidity dries up in some markets”, adds Mr Badenhorst.
The proposed solution is to blend the denomination of the investment in a basket of currencies – similarly secured by a multiple-currency denominated bank hedge.
Vuyo Mafrika, Senior Manager, Client Solutions for Global Markets at Standard Bank, believes that this approach would entail a complete shift in thinking about how investments, leases and debt instruments are denominated.
For example, “denominating a portion or all of an African commercial property’s liability in a basket of currencies provides at least a partial hedge against currency depreciation and liquidity shortages. Then, entering into a bank hedge based on a basket of currencies will ensure that the bank acts as guarantor – or liquidity provider of last resort – when it comes to repatriating earnings, or debt obligations, incurred against the basket of foreign currencies”.
In other words, this blended or hybrid approach for managing currency volatility and liquidity risk in Africa has two parts. Part one provides a partial hedge against depreciation, part two provides a multiple-currency bank hedge, partially relieving the business of the obligation of sourcing US dollars to make repayments or repatriate earnings.
This blended approach reduces currency volatility risk, while also ensuring that the bank assumes some of the risk, or obligation, of providing the requisite foreign currency when earnings need to be repatriated – rather than the business.
The partial hedge-against-depreciation element is best illustrated as follows:
The Tanzanian Shilling has depreciated 32% against the US dollar in the last five years. Over the same period, however, it has only depreciated; 23% against the British pound, 15% against the euro, 13% against the Kenyan shilling, 3% against the Canadian dollar, and 1% against the Japanese yen.
In this example, investment in a real estate development in Tanzania – denominated exclusively in US dollars (which is the norm) – would see either the investors or the end-users (tenants) having to account for the 32% depreciation in local currency earnings. If, however, a third of the debt was in euros, a third in yen, and only a third in US dollars, the client would have achieved a better average by funding through this basket of currencies.
“From a tenant perspective, the basket could also act as an indexing mechanism, reducing rental fluctuation risk,” adds Mr Badenhorst.
Moreover, in environments where central banks focus almost exclusively on managing currency levels through high interest rates, value will always need to be stored in foreign currency – largely US dollars. When US dollar inflows decrease, central banks are often forced to allocate US dollars selectively in auctions.
“Having your commercial property investment denominated in a basket of currencies gives financial institutions more currency alternatives to provide the money to repatriate earnings,” explains Mr Badenhorst. This is especially so in East and Southern Africa’s more diversified economies where inflows in euros, Canadian dollars and yen, for example, might remain strong even where central banks experience short term US dollar shortages.
Yet another advantage of the blended hedge approach is that it buys businesses more time.
Generally in Africa, financial institutions run out of US dollars first, often retaining healthy holdings of euro, yen, rand and renminbi even after their US dollars have dried up. When financial institutions run out of US dollars investors are unable to repatriate their earnings – and have to wait in line until the institution replenishes its US dollar holdings.
“Having part of a commercial property investment denominated in currencies other than the US dollar means that financial institutions will be able to continue allocating foreign currency to investors seeking to repatriate earnings – even after US dollars have run out,” says Mr Badenhorst. If liquidity shortages persist, however, eventually all currencies will run out.