Commercial Real Estate Derivatives: The Developing U.S. Market

Article excerpt

"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. …