Commercial real estate investors may soon have a new option to protect against market losses, thanks to a series of price indexes published jointly by Moody’s Investors Service and Real Estate Analytics LLC (REAL). The set of market indicators are expected to provide a platform for trading commercial real estate derivatives, which can be used to hedge investments.
Engineered by the MIT Center for Real Estate, the 29 Moody’s/REAL Commercial Property Price Indices draw on repeat sales data collected by Real Capital Analytics, a New York-based research firm that tracks transactions of $2.5 million or more. The indexes reflect the difference in sums paid for specific properties compared with the last time those assets changed hands, which provides a direct tie-in to current market prices.
Derivatives contracts enable investors to quickly stake a position in a market without having to acquire a hard asset. Portfolio managers can use derivatives to quickly achieve diversification goals without going through the process of finding and acquiring properties. As a hedge against lost value on a hard asset, an investor can sell short against the index, so that market losses (and lost value in owned real estate) will be offset by the increased value of the derivative contract.
Sound complicated? It is. That’s one of the reasons derivatives haven’t taken a strong hold in U.S. commercial real estate, and educating investors is an ongoing challenge for derivatives here.
The field is expanding, however, and other indexes already track commercial real estate values to provide a basis for derivatives trading. Those include the NCREIF Property Index published by the National Council of Real Estate Investment Fiduciaries, which uses appraisal data to calculate value changes. Earlier this year, NCREIF inked agreements with four banks for a total of seven that provide derivatives trading based on its index.
The market is better established in the United Kingdom, where real estate acquisitions incur a 4% tax that isn’t applied to derivatives. In 2006, trading based on an index published by U.K. firm Investment Property Databank totaled nearly $8 billion. That equates to about 10% of commercial real estate investment volume in the U.K., according to Neal Elkin, president of Real Estate Analytics.
Given that U.S. real estate transactions amounted to approximately $330 billion in 2006, there is the potential for “tens of billions of dollars” in domestic derivatives trading, Elkin says. “Once these tools are better understood, we’ll go very quickly past that, but we’re not there yet,” he says.
Proponents of the Moody’s/REAL indexes say their data will reflect values more quickly and accurately than systems that rely on appraisals. “The Moody’s/REAL indices track same-property price changes,” says Moody’s senior vice president Sally Gordon. “This method avoids the lags and distortions that can occur with other commercial property value measurements using appraisals or average prices.”
The new system’s creators hope that data from Real Capital Analytics and analysis by Moody’s will instill investors with confidence and boost the commercial real estate derivatives market. In order to tap that anticipated business, Real Estate Analytics is forming a brokerage division with exclusive rights to the Moody’s/REAL indexes and non-exclusive derivatives offerings based on other commercial real estate indexes.
Elkin believes the market is ripe for derivatives to catch on with commercial real estate investors. “In a market that’s going up 10% a year, nobody’s thinking about hedging their portfolio. But we really are at a tipping point, where the hedging of assets starts to make sense.”