In Latin America, those investing in large hotel real estate portfolios will be confronted with both systematic (market) risk and unsystematic (property-specific) risk.  Most hotel investors are unaware that such risk can be hedged by a variety of basic derivative instruments.

Day in and day out, there are examples of Latin American risk such as the Argentine government�s negotiations with the IMF to reach a workout on its massive sovereign debt.  Brazil�s currency, the real, has lost more than 50 percent of its value since the beginning of the year, despite government interest rate hikes.  Chile�s normally strong peso has lost its growth against the American dollar.  Even Mexico�s economy is slowing with its exports impacted by shrinking U.S. demand and its overvalued currency.  However, many predict a Latin American recovery by the beginning of 2003, led by the global and U.S. economic recovery. 

Although most traded securities are infrequently backed by real estate and, therefore, can rarely impact the returns on the real estate portion of a portfolio directly, potential hedging vehicles do exist for trading derivative assets for more effective real estate portfolio management.  In the exotic arena of Latin American real estate finance, there are various strategies available via investment banks that can hedge some of the risk to which capital-intensive hotel investments are exposed. 

Investors who acquire Latin American hotel real estate face not only the general risks associated with property investment, but also an exposure to currency risk.  For instance, a large and sophisticated opportunity fund in the United States (such as Equity International Properties) buys an interest in a substantial hotel portfolio in Sao Paulo from a Brazil-based joint venture (JV) partner.  Cash flows from the portfolio will be received in Brazilian real, which must be converted into American dollars.  If the value of the real falls (as shown in Exhibit A), the profitability of the investment to the U.S.-based opportunity fund will be reduced (exposure to negative currency risk).  In turn, if the value of the real rises, the profitability of the investment will increase (exposure to positive currency risk).
 

A portion of this currency risk volatility can be offset by the use of basic derivative instruments, or hedging vehicles.  By using swaps or forward contracts (see Exhibit B), the opportunity fund can agree in advance to exchange a fixed amount of cash flows received from the portfolio investment for a fixed amount of dollars. 

In other words, the opportunity fund manager today makes an agreement to deliver a fixed amount of funds each year in dollars with the investors in the fund.  The investors now are exposed to currency risk between the Brazilian real and U.S. dollar.  To eliminate this risk, they should buy a hedging vehicle today to eliminate their currency risk in the future.  The fund manager could buy a forward contact for each of the future payments.  If the Brazilian real�s value goes down versus the dollar, the forward contract does the opposite.  The forward contract is protecting (or hedging) the hotel portfolio�s currency risk exposure for negative fluctuations.

Options can also provide a useful tool for hedging against currency risk in Latin America.  Suppose a U.S. investor purchases a put (right to sell) option on the Chilean peso to �protect� the cash flow from a significant Santiago mixed-use hotel investment.  If the value of the peso rises, the put will expire worthless.  If the value of the peso falls, the profit from the put will offset the loss in value of peso received from the investment.
 

Protection of inherent capital value, as opposed to cash flows, from currency fluctuation is more difficult to attain.  For example, a Miami-based investor purchases a portfolio of 3,000 hotel rooms in Rio de Janeiro and plans to sell the properties after a fixed period of time.  If the holding period is long enough (10 years), it is unlikely that the investor will be able to purchase any instruments to hedge Brazilian currency exposure.  Even for shorter-term exposure, the risk can�t be hedged altogether.  The investor, however, can take on a five-year forward agreement, which would call for a fixed amount of currency.  As the investor cannot know today what the selling price will be in five years, no fixed hedge can remove all of the currency risk, but some risk hedging is better than none at all.

In addition to currency risk, Latin America is currently burdened by interest rate volatility.  Suppose a Chicago portfolio manager owns a share of a large Buenos Aires hotel/office project financed by a floating-rate loan.  The manager is probably pessimistic about the future course of interest rates in Argentina and is averse to bearing interest rate risk.  The effective financing of the project can be changed by entering into an interest rate swap agreement.  The underlying mechanism of such a swap implies that Lender A, who is making the loan, offers a floating rate.  The Chicago portfolio manager wants to lower the risk exposure, and therefore, requires Lender A to enter into a swap agreement with Lender B who, in turn, will speculate that interest rates will fall and is willing to offer a fixed rate.  This way the floating rate is essentially converted into a fixed rate through the interest rate swap mechanism. 

To further explain, take, for example, a global bank that funds long-term assets, such as mortgage originations held in a portfolio yielding 8.5%, with short-term liabilities, such as customer deposits paying 5.5%.  In doing so, the bank exposes itself to interest-rate risk.  That is, if rates do rise, the bank may end up paying 10.0% to borrow money to fund the assets yielding 8.5%, leading to losses for as long as short-term rates remain elevated.  An interest rate swap can reduce this imbalance by enabling the bank to receive a floating-rate stream of income while paying a fixed rate on the underlying deposits.  If interest rates do indeed spike, then the higher return yielded when the variable-rate swap adjusts upward will offset the losses otherwise resulting from paying the higher rates on deposits.

In the stock market, investors can easily buy and sell equities to change their asset mix, or sell a stock short if they think it is overvalued.  But international hotel real estate investors haven�t really had an easy way to change their asset mix, or simply to hedge their investments, especially when real estate values nose-dive. 

Derivative instruments serve a valuable and necessary role in modern financial markets where interest rate and currency volatility have become a fact of the business world.  Although real estate securities might be in the infancy of derivatives trading relative to the more established asset classes such as stocks and bonds, basic derivative products are available that would open up a world of hedging possibilities for future hotel investors.

Jones Lang LaSalle Hotels, the world�s leading hotel investment services group, provides clients with value-added investment opportunities and advice. Its recent two-year success story includes the sale of 13,994 hotel rooms to the value of US$1.4 billion in 48 cities and advisory expertise for 173,021 rooms to the value of US$32.6 billion across 343 cities. Jones Lang LaSalle Hotels� services include transactions, mergers and acquisitions, financial advice and capital raising, valuation and appraisal, asset management, strategic planning, operator assessment and selection and industry research. Jones Lang LaSalle (NYSE: JLL) is the world�s leading real estate services and investment management firm, operating across more than 100 key markets on five continents.