"Derivatives make markets more complete--that is, they make it possible to hedge risks that otherwise would be unhedgeable.... [R]isks are born by those who are in the best position to bear them and firms and individuals can take on riskier but more profitable projects by hedging those risks that can be hedged. As a result, the economy is more productive and welfare is higher." --Rene Stulz, "Should We Fear Derivatives?" Journal of Economic Perspectives, Summer 2004
OVER THE PAST DECADE, U.S. INSTITUTIONAL REAL ESTATE HAS evolved into a dynamic, more widely accepted mainstream asset class. The securitization revolution of the 1990s helped produce today's robust public real estate investment trust (REIT) and commercial mortgage-backed securities (CMBS) markets. It also has facilitated major capital flows into real estate in recent years that have strengthened linkages between private real estate asset markets and wider national and global capital markets. This shift has transformed real estate financial structures, capital sources and investment products.
The real estate sector continues to evolve at a rapid pace, with the emerging commercial property derivatives market being the latest innovation. There is significant interest by many real estate market participants in the development of commercial property derivatives. Investors are watching with interest to see if this new way to gain exposure to the real estate asset class and hedge private real estate risk will materialize and revolutionize the institutional real estate world, as it has in stock and bond markets around the world. Real estate is the last major asset class without a significant derivatives market.
Property derivatives represent a new way for investors to gain or reduce exposure to the real estate asset class, quickly and without directly buying or selling properties, while relying on the performance of a real estate return index. The speed and ease of execution, reduced upfront capital requirement and ability to protect real estate portfolios on the downside provide added flexibility in executing real estate investment and portfolio risk management strategies. It seems to be a natural next step in the evolution of real capital markets, continuing the transition from a private asset class characterized by high transaction costs and the inability to sell short to one with significant public market integration and the associated fast pace of financial innovation. With it would come improvement in price discovery and market pricing.
In 2005, the National Council of Real Estate Investment Fiduciaries (NCREIF) gave Credit Suisse an exclusive license to offer derivative contracts, in the form of return swaps, based on NCREIF property return indices. Significant trading of NCREIF-based swaps did not materialize, and in October 2006, Credit Suisse relinquished the exclusive license it received from NCREIF. It is widely believed that the exclusive arrangement hampered growth and development because it prevented needed competition between investment banks and other players wishing to create liquidity in derivatives on NCREIF indices. Since then the "buzz" about derivatives has intensified.
In March 2007, NCREIF began licensing its indices on a non-exclusive basis. This is more along the lines of the successful model adopted in the United Kingdom, where the property derivatives market has experienced rapid growth and development over the past two years. Today, seven investment banks have agreements with NCREIF, and trading in derivatives is taking place, with approximately $300 million traded as of early September 2007. While clearly in the early stages of development, there is significant momentum as new players and other tradable indexes have emerged and jostle for position in this young market.
While many are excited about the new investment and risk management possibilities offered by property derivatives, others are skeptical about investors' willingness to embrace these new tools. There is also concern that trading by nontraditional real estate investors with a short-term focus (e.g., hedge funds) will add volatility to and potentially destabilize the private property market. To these market participants, real estate represents tangible, bricks and mortar assets, whereas derivatives are seen as complex financial instruments created by Wall Street investment bankers.
Is there a need for commercial property derivatives? What are the implications of growth in real estate derivatives for investment in traditional real vehicles? This article aims to bridge the knowledge gap that exists between traditional real estate players and the Wall Street derivatives world. It will serve as a primer on both the basic structure of property return swaps written on real estate return indexes and the real estate investment performance indices upon which derivative contracts may be based.
PROPERTY RETURN INDEX SWAP BASICS (2)
A "derivative" asset is one whose value is determined by, or derives from, the value of another asset or bundle of assets. Financial derivatives come in a variety of forms, including options (calls and puts), futures and swaps, as well as more exotic complex instruments. Exhibit 1 (below) provides an overview of financial option terminology for readers unfamiliar with this area of the finance world. The derivatives offered to date on the NCREIF index are "swaps" that come in two forms. One allows investors to take a position in either the NPI appreciation or total return, buying ("going long on") or selling ("going short on") the NCREIF index return. The second type of product allows investors to swap total returns on two different NCREIF property sectors (e.g., swap office for retail).
Exhibit 2 (below) shows how the appreciation return swap works. Investor L takes a long position in the index, meaning it receives the real estate return each period (quarter or year depending on how the contract is specified) in exchange for paying the London Interbank Offered Rate (LIBOR--the interest rate that banks charge one another for lending money) plus a spread. On the other side of the exchange, Investor S agrees to pay (i.e., sell) the index return and in return receives LIBOR plus a spread. There is no upfront principal involved. The swap contract is based on a notional principal amount upon which cash flows to be exchanged (or swapped) are calculated. In this example, the trade takes place in the over-the-counter (OTC) market--that is, not in an organized options exchange such as the Chicago Mercantile Exchange. An investment bank executes the trade. (3) One or both parties may work with an "inter-dealer" broker, a specialist firm that facilitates the execution of derivative contract trades, fosters price discovery and creates liquidity in the marketplace. The contract term is specified upfront and typically would be for two or three years, with cash settlement every quarter (or possibly annually) shortly after the index numbers are made available.
The return swap allows the two investors to execute real estate strategies that they cannot accomplish in the private real estate market. Investor S might be a large pension fund that is over allocated to real estate, possibly because of relatively poor performance in stock and bond markets. S can reduce exposure to the real estate asset class without having to sell properties. The swap allows Investor S to execute this strategy quickly while retaining ownership of the physical assets. Investor L could be a small pension fund looking to gain exposure to the real estate asset class. The swap allows L to get into the real estate game quickly with exposure to a diversified portfolio, such as the NCREIF index.
In another scenario, L and S could be two investors with different expectations about the direction of the market, with L betting on the market rising and S the market taking a downward turn. The two might be investment managers or pension funds with existing real estate portfolios using derivatives to fine tune real estate allocations and manage portfolio risk as part of the overall real estate strategy. In this case, S uses the swap to reduce or possibly even eliminate, with a large enough notional position, the systematic real estate market component of its portfolio. This might be motivated by the goal of focusing on alpha, or the desire to buy portfolio level insurance against a real estate downturn. This is similar to buying a "put" option on the index to provide downside protection. Of course, this story assumes that the investors have portfolios that closely track the index.
Alternatively, S and L could be more opportunistic players (e.g., hedge funds), possibly without real estate holdings at all, looking to speculate on short-term movements in the real estate index. Of course, it is crucial that demand exists on both the long and short sides of the market, deriving from either portfolio adjustment motivations, or disagreement about the direction of the market, or both; it is a two-sided market that requires enough breadth and depth to create the requisite liquidity.
This might all sound good in theory, but is it needed and will it work in practice? The main determinant of the long-term viability of a robust, liquid property derivatives market is the value it has to investors. What does the real estate investment industry gain? Index return swaps allow investors to adjust exposure to real estate without buying or selling properties, thereby creating flexibility for portfolio management, while eliminating the required physical delivery of the asset. Derivatives, therefore, help to overcome the main disadvantages of private real estate investment, including high transaction costs, long transaction lead time, lack of liquidity and inability to sell real estate "short." (4) Once sufficient liquidity is achieved in the marketplace, investors will be able to act quickly on both the short and long sides of the market. The result will be significant improvement in price discovery and ultimately efficiency in the private real estate market. In addition, as derivate markets continue to develop around the world, swaps should prove to be an efficient and economical way to gain exposure to international real estate markets.
Experience in other asset classes suggests that it is needed and it will work, and also that the market could develop rapidly once it gains momentum. Property sector evidence comes from the recent experience of the U.K. commercial derivatives market, where the market has gained significant momentum. (5) At last count, more than 15 banks are licensed to trade index return swaps based on Investment Property Databank (IPD) return indices. (6) Exhibit 3 (below) provides U.K. trading volume data. Since the end of 2004, trades totaling almost $14.1 billion ([pounds sterling]7 billion) in notational value of IPD index swaps have taken place. After a slow start, in the first quarter of 2005, over-the-counter trading exhibited a sharp uptick in 2006, and in the first quarter of 2007, trades worth nearly [pounds sterling]3 billion were executed. The increased activity in 2006 and 2007 U.K. derivative trading suggests a growing familiarity and acceptance of property derivatives.
COMMERCIAL PROPERTY RETURN INDICES FOR DERIVATIVES TRADING
To date, both the U.K. and U.S. property derivative markets have developed as index return swap markets, with contracts written on only IPD and NCREIF appraisal-based, benchmark return indices in each respective country. This may change in the United States, as there are (at least) three additional indices hoping to compete for derivative trading business to allow investors to create synthetic positions in private real estate. (7) It seems logical that the NPI was the first index to be licensed for trading in the United States, given its familiarity to institutional investors and widespread use as a benchmark return index. There is some concern, however, that the NPI does not represent the ideal index upon which to grow the derivatives market, or that it should not be the only option available to investors.
The NPI is the primary index used by institutional investors to analyze the performance of U.S. commercial real estate and used as a benchmark for actively managed core real estate portfolios. It is well known that the use of quarterly appraised values results in "smoothing" and lagging of the returns compared with indices based on actual transactions. Smoothing derives from the valuation techniques employed by appraisers, the staggered timing of appraisals conducted within any given quarter, and the fact that not all properties in the index are valued each quarter. The upshot is that the NPI is in many ways an annual index that is partially updated each quarter, making it an imperfect tool for analyzing current performance. In addition, compared with the IPD index, the NPI covers a relatively small proportion of the overall commercial real estate market. (8)
These potential problems with the NPI as an indicator of current return dynamics have helped stimulate the development of other types of indices that hope to compete in the derivatives trading space. These include:
* Global Real Analytics (GRA) indices based on average sale price per square foot. The GRA indices are being developed through a partner ship with Standard & Poor's (S & P).
* Real Estate Analytics (REAL) indices derived from repeat sales (same property realized price changes) of properties in the Real Capital Analytics (RCA) transaction database.
* REXX indices based on metropolitan area rents as well as capital values changes.
Exhibit 4 (on page 37) provides an overview of each of these indices, including information about the index provider, as well as index characteristics, with an emphasis on the features that differ between the indices. It also contains links to the index providers where readers can obtain data, as well as additional details and in many cases, "white papers" on the index methodology.
Exhibit 5 (on page 38) compares the capital or value component of the appraisal-based NPI with a transaction-based value index derived from the Real Capital Analytics (RCA) transaction database, one of the indices discussed in Exhibit 4. It also plots a transaction-based version of the NCREIF index (TBI). While the TBI has not been licensed for derivative trading, there is no reason it could not be in the future. Academic researchers have adopted several approaches to deal with the appraisal issues, the most promising of which are techniques that employ sales of properties to develop transaction-based indices for private commercial real estate.
The TBI, or transaction-based index, is a quarterly "hedonic" index derived from the sale prices of properties in the NCREIF database. The hedonic-price approach uses regression techniques to control for differing property characteristics, and what is called sample selection bias, to create a constant quality price index. (9) The RCA-based index derives from the application of a repeat sales econometric methodology to transaction prices of properties that have sold multiple times during the period covered by the data. The TBI is based on properties sold from the NCREIF index database, whereas the RCA index derives from a much broader and encompassing sample, since the RCA database tracks transactions of all properties in the United States with sale price of $5 million and greater. As might be expected, the three value indices share a common trend. The transaction indices, however, are more volatile than the smooth NPI and have different slopes at times, as evidenced by the crossing of the indices at different points in time. This suggests that institutional class properties held by NCREIF members perform differently at times that the broader property asset market in terms of appreciation returns.
The presence of multiple indices appears to be causing confusion, especially amongst non-traditional real estate players. These multiple indices potentially inhibit the growth of the market. With four indices at the outset, the market could be spread too thin, and this will inhibit the scale and liquidity each needs to achieve market development. However, upon further reflection, it seems that, for two reasons, the presence of multiple indices could be a positive in terms of the long-term development of the market. First, at the micro or individual investor level, investors can choose to execute derivative strategies on the index that best suits their specific situation. Second, at the macro level their coexistence may help to quicken the pace of development of the derivatives market.
Specifically, the presence of multiple indices with differing characteristics allows investors to trade across the indices to exploit arbitrage opportunities that might exist. Consider the differential movement in the indices shown in Exhibit 5. This type of trading should bring additional capital into the real estate investment industry quickly, through derivative, not property, transactions. This would improve price discovery and the efficiency of the private property market.
What is needed is continued objective debate and education about the swap products and the various indices. It is hoped this article has made a positive contribution in this regard.
This article examined the development of the commercial real estate derivatives market in the United States. It aims to bridge the knowledge gap that exists between traditional real estate players and the Wall Street derivatives world. It does so by providing a primer on both the basic structure of property return swaps written on real estate return indexes and the real estate investment performance indices upon which derivative contracts may be based. It details potential uses for individual investors and implications for the real estate market as a whole. Having a basic understanding of commercial property derivatives and the indices upon which contracts are written is important, even for real estate investors who do not plan to buy or sell property derivatives.
(1) This article is based on a presentation given by the author at The Counselors of Real Estate's Midyear Meeting in Montreal in April, and is an expanded and updated version of the article, "Commercial Real Estate Derivatives: They're Here ... Well, Almost," which appeared in the Winter 2007 issue of the PREA Quarterly. The author thanks Marc Louargand, the moderator of the derivatives session at the CRE Midyear Meeting, for helpful discussions and comments.
(2) This section is based in part on material presented in Jeff Fisher's, "New Strategies for Commercial Real Estate Investment and Risk Management," PREA-sponsored special issue of The Journal of Portfolio Management, Fall 2005; and David M. Geltner, Norman G. Miller, Jim Clayton and Piet Eichholtz, "Real Estate Investment Management and Derivatives," Commercial Real Estate Analysis and Investments, Chapter 26 (2nd ed.) (South-Western Educational Publishing, 2007).
(3) Exhibit 2 makes it seem as though Investors S and L want to take exact opposite positions in the index swap in terms of the same notional value. In practice this does not have to be the case. If, for example, Investor L wanted to go long $30 million but Investor S wanted to go short $50 million, then the investment bank would execute the $30 million notational swap and then execute another swap for the remaining $20 million short position. Alternatively, the bank could take the $20 million long position itself to facilitate the trade and possibly swap this with an investor looking to short the index at a later date.
(4) Property derivatives would therefore help investors manage the two top risk factors in real estate--liquidity risk and lack of reliable valuation data--as identified in a recent survey of institutional investors. See Exhibit 8 in Ravi Dhar and William N. Goetzmann, "Institutional Perspectives on Real Estate Investing: The Role of Risk and Uncertainty," PREA Research, May 2005.
(5) In thinking about the prospects for the real estate derivative market, some market watchers have drawn parallels to the growth and development of the credit default swaps (CDS) market. The CDS market grew from about $180 billion in notional amount in 1997 to $5 trillion in 2004 to an estimated $17 trillion as of mid-2006 (Sources: British Bankers Association [BBA] and the International Swaps and Derivatives Association [ISDA].)
(6) Information about IPD indices is available at www.ipdglobal.com.
(7) Derivatives on a public REIT index began trading earlier this year, as the Chicago Board of Trade (CBOT) launched a new futures contract based on the Dow Jones U.S. Real Estate Index.
(8) The NPI is derived from a sample of the population of stabilized, unleveraged, institutional class properties. The main use of the NPI is as a benchmark for portfolios of core properties. It makes perfect sense that investors benchmarked against the NPI will be drawn to NPI index swaps. Other investors who want to trade on more timely changes in property market conditions may prefer transaction-based indices that might come to the market. For an excellent discussion of benchmark and market condition indices, see David Geltner and David Ling's, "Indices for Investment Benchmarking and Return Performance Analysis in Private Real Estate," International Real Estate Review, Vol. 10 (1), 2007.
(9) Both the TBI and RCA-based data are publicly available at the MIT Center for Real Estate website: http://web.mit.edu/cre/research/credl/tbi.html. Readers who want more details might want to check out the following two practical overviews of NPI transaction-based indices: Donald Haurin's, "US Commercial Real Estate Indices: Transaction-Based and Constant Liquidity Indices," Bank of International Settlement (BIS) Paper No. 21; and David Geltner's, "Transaction Price Indexes and Derivatives: A Revolution in the Real Estate Industry?" International Council of Shopping Centers Research Review, Vol. 14, No. 1, 2007.
BY JIM CLAYTON, Ph.D.
About the Author
Jim Clayton, Ph.D., is the director of research at the Pension Real Estate Association (PREA), a nonprofit trade group representing more than 500 member firms, including tax-exempt investors (pension funds, endowments, foundations and more), real estate asset managers, advisors, consultants, investment bankers, real estate investment trusts and others. Working closely with the PREA Research Committee, be leads PREA's research efforts through original applied research, coordination of sponsored external research and participation in other PREA educational and outreach activities. He also writes a regular capital markets column in the PREA Quarterly member magazine. Prior to joining PREA in the fall of 2006, Clayton was a faculty member in the department of finance and real estate at the University of Cincinnati. His research has been published in the major academic and practitioner real estate journals and he has presented at numerous industry events, in the U.S. and abroad. He is a past recipient of the Homer-Hoyt Institute post-doctoral fellowship and serves on the editorial boards of several leading research publications, as well as the advisory board of the Real Estate Research Institute (RERI).
Exhibit 1 Background on Financial Derivatives: Terminology and Concepts
A derivative is an asset that derives its value from the value of another asset (e.g., a stock) or a bundle of assets (e.g., a stock index).
TYPE OF DERIVATIVE
Option The "right" but not obligation to buy (call) or sell (put) an asset at a specified price Forward/Future Obligation to exchange an asset at a specified price on a specified date in the future Swap Contract to exchange cash flows over a specified period of time; based on a "notional" principal.
MOTIVATION: Why do investors use derivatives?
* Synthetic investment: receive asset return without acquiring the asset
* Hedging/risk management: downside risk insurance
* Portable "alpha" strategy: eliminate/reduce systematic risk from a portfolio
* Speculation: make a leveraged bet on the direction of value change
Exhibit 4 The Four Emerging U.S. Commercial Real Estate Indices for Derivative Trading Indices Provider Information Basic Index Characteristics NCREIF National Council of Real * Quarterly unlevered returns Estate Investment (total, income and appreciation) Fiduciaries Property at the national and regional Index (NPI) is derived level by property type back to from the performance of 1978. MSA level returns as well. institutional class * Appraisal-based: Capital returns properties owned by are derived from changes in investment managers and appraised values. NCREIF returns pension funds (plan tend to lag "true" market sponsors). returns, due to the nature of the www.ncreif.org appraisal process and the fact that not all properties are reappraised each quarter. * As of 1st quarter 2007 comprising 5,466 properties with an estimated aggregate market value of $267 billion. * The benchmark for most institutional core real estate portfolios. S & P/GRA Standard & Poor's * Quarterly price indices and (S & P) has partnered capital returns at the national with Global Real and regional levels, as well as Analytics (GRA) to property type on a national produce the S & P/GRA basis, back to 1994. Commercial Real Estate * Transaction-based: Price index is Indices derived as the 3-month moving ([SPCREX.sup.TM]), average of average sale price per which are to begin square foot. Average sale price trading on the Chicago per square foot figures are Mercantile Exchange derived using a proprietary (CME). algorithm applied to property- www.graglobal.com/ level transaction price per index.php?section= square foot data observations. products&page=aboutCREX RCA-based Real Capital Analytics * Monthly price indices and capital (RCA), a national real returns at the national level estate data vendor back to 2000; quarterly indices specializing in tracking for core property types and commercial real estate annual indices for select MSAs. transaction activity and * Transaction-based: Constructed prices, has partnered using a statistical/econometric with the MIT Center for methodology applied to repeat Real Estate (MIT/CRE) sales of individual properties and the firm Real Estate (same-property realized price Analytics LLC (REAL) to changes) in the RCA database. produce a series of Similar to methodology used to property price indices. construct the Case-Shiller/S & P http://web.mit.edu/cre/ housing prices indices that are research/credl/rca.html traded on the CME. www.realindices.com * RCA database includes most property sales of more than $2.5 million. REXX Rexx Index venture * Quarterly returns (total, rent includes Cushman & and capital) at the national Wakefield and Newmark, level as well as for 15 major Knight, Frank as metro areas, back to 1994. minority owners and data Office only at the current time. contributors. * Proprietary model based on www.rexxindex.com current micro (space market) variables including rents, vacancy rates and leasing activity, as well as key macro variables such as interest rates and inflation. * Focus on metro level rent indices to allow investors to hedge or leverage on performance in specific local markets. Source: PREA Note: As of press time, the NCREIF index is the only index licensed for trading. Recent developments indicate this may change in the near future. As of the 3rd quarter of 2007, Moody's Investor Services has taken over production of the REAL indices. These are now the "Moodys/REAL Commercial Property Price Indices" or Moody's CPPI. REAL is working to establish a platform or trading derivatives on this index. On September 19th, the CME Group announced that futures and options based on the S & P/GRA indices would begin trading on the exchange on October 28th.…