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

(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).

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Exhibit 1 Background on Financial Derivatives: Terminology and Concepts

DEFINITION

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