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Derivatives

Can they revolutionize the real estate industry?

Across the world, derivatives are an important tool used when investing in stocks, bonds and commodities. While most industries have embraced derivatives, the commercial real estate industry has struggled to introduce property derivatives in the United States.

In fact, commercial real estate is the only major asset class in the world that doesn't have a supporting derivative market, experts note. If it did, the derivatives market would likely eclipse $1 trillion, according to David Geltner, a professor of real estate finance and director at the Massachusetts Institute of Technology.

"If you total up all the derivatives trading on the different stock market indices, it accounts for more than $3 trillion a year," Geltner says. "Given the size of the commercial real estate market, there's every reason to believe that a derivatives market would be huge."

Practical uses

The term "derivative" refers to assets that derive their value from another group of assets. It applies to several financial tools including futures, options and swaps. In commercial real estate, there are a number of practical uses. Most importantly, derivatives can help investors manage their real estate related risk without buying and selling assets, and they can help investors allocate funds to real estate without actually owning any property.

For example, by using a derivative "swap" an investor can get in and out of real estate very quickly and create synthetic portfolios. Investors can also increase or decrease the risk in their existing portfolios through the buying ("going long") or selling ("going short") of returns.

"Derivatives have the ability to change the way people view the asset class," says Neal Elkin, president of Real Estate Analytics LLC, an affiliate of Real Capital Analytics that has created its own set of indices that can be used for derivative trades. "As more institutional investors get involved in commercial real estate, they're looking beyond core markets, and we felt that they would be receptive to more efficient ways to measure and manage risk. That's what derivatives are all about."

But, commercial property derivatives have experienced some difficulties in getting off the ground in the U.S. They got a false start two years when the National Council of Real Estate Investment Fiduciaries (NCREIF) licensed its property index exclusively to Credit Suisse. The index, known as the NPI, is widely considered the benchmark index for commercial property returns in the U.S. 

Some industry players say that NCREIF's exclusive arrangement with Credit Suisse stalled the commercial property derivatives market. It certainly prevented competition between investment banks and others who wished to trade on the NPI, and without that competition, the market was unable to build critical mass.

That's why Investment Property Databank Ltd. (IPD), the London-based company that provides indices for derivative trades in the U.K., entered the U.S. two years ago and began collecting data to create its own U.S. index, says founding director Ian Cullen.

Cullen notes that IPD refused to offer exclusivity to any bank, and he believes the availability of the IPD index allowed the U.K. derivatives market to gain traction – something the U.S. market was unable to do.

About 10 months ago, Credit Suisse gave up its exclusive license and since then at least seven investment banks have signed agreements including Bank of America, Goldman Sachs and Merrill Lynch. Since then, a few derivative trades have occurred, many of them brokered by GFI Group Inc., which partnered in November 2006 with CBRE Melody to broker real estate derivatives in the U.S.
 
Although GFI's clients prohibit it from discussing the number of deals and volume that it has done in the U.S., the firm has completed several deals based on the NPI, says Phil Barker, vice president of real estate derivatives.

But, most investors are still standing on the sidelines, waiting for someone else to take the first leap. In fact, a survey conducted by the Pension Real Estate Association found that 15 percent of its members are "giving some serious thought to employing real estate derivatives." For their part, the main problems are pricing and market liquidity, says director of research Jim Clayton.

"At the beginning of a new market, the most crucial thing is liquidity – it's a huge chicken and egg problem," says MIT's Geltner. "You don't have trading because you don't have liquidity and you don't have liquidity because you don't have trading."

Good role model

The U.K. commercial property derivatives market provides a good model for the U.S., experts note. "Industry people can look to the U.K. market to see what they did well and not so well and apply those lessons to the U.S. market," says Richard Buttimer, Ph.D. and professor at Belk College of Business at the University of North Carolina.  

In the U.K., nearly 330 individual trades totaling $10 billion have occurred since January 2005, according to Cullen. There, the market started slowly too, with four trades occurring in the first quarter 2005. But, it grew quickly and 65 trades totaling $2.8 billion occurred in the third quarter of 2006. And, in December 2006 the first French derivatives trade took place, based on the French IPD index.

"When investors start dancing instead of standing around there will be numerous ways they can use derivatives," says Louis Wolfowitz, managing director of capital markets for Cushman & Wakefield Inc., pointing out that investors can invest in commercial real estate and gain exposure to specific sectors or markets without buying property.

However, the U.K. market has a leg up in one important area – U.K. investors have embraced the IPD Index as the benchmark. The appraisal-based index encompasses 70 percent of the property market and most of the properties in the database are re-valued on an annual basis (some are even done quarterly or monthly).

In the U.S., however, several indices are in development. The NPI is leading the pack today, mostly because institutional investors already use it and are comfortable with it. But, those who are intimately involved in the derivatives market question whether the NPI is the most appropriate index.

Because the NPI only covers about 7 percent of the total commercial property inventory in the U.S. and the assets aren’t routinely appraised, detractors contend that any related indices might not be as accurate as they need to be for derivative trading.

The three additional indices are: the Global Real Analytics Commercial Real Estate Index (SPCREX), backed by Standard & Poor's, the Chicago Mercantile Exchange and Global Real Analytics; the Real Estate Analytics Indices (RCA) created by Real Capital Analytics and MIT; and the Rexx Real Estate Property Index, which includes backing from Cushman & Wakefield.

"When you have an asset class that is homogenous and fungible, one index is fine," says Real Estate Analytics' Elkin. "But, here in the U.S., we have very nuanced markets, so we need multiple indices."

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