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

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.

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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.

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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.

SUMMING UP

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.

ENDNOTES

(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.