Commercial real estate derivatives: the developing U.S. market.

"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.

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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.