US Real Estate Derivatives
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US Real Estate Derivatives
The market for US real estate derivatives, while in a nascent stage, made significant progress in 2007. There are now a diverse set of indices and methodologies being used to create and structure real estate derivatives, for both residential and commercial real estate.
Market History
A handful of small companies in the United States have been instrumental in helping to build this marketplace. DELTA Rangers, Inc. (DRI), a closely-held company that develops and commercializes new financial products, filed a patent and other intellectual property covering core concepts in this market in 2003. DRI partnered with Credit Suisse in 2004 to transact swaps based on the NCREIF index, under exclusive license from NCREIF. Credit Suisse completed two transactions, and spent significant resources helping to establish demand for these types of derivatives.
However, DRI recognized the need for a new set of indexes to serve as benchmarks. In order to capture the full range of potential users, including mortgage lenders, commercial banks and active traders such as hedge funds, swaps and other products needed to be based upon indices that accurately reflect the “spot market”, or current transaction values of the marketplace.
DRI reached out to Corridor Capital LLC, a firm founded by Pierre Wolf, former senior managing director and founder of the Derivative Products Group at Fimat USA. DRI and Corridor had worked together successfully on past projects. Corridor was established by Mr. Wolf as a conduit between major market participants, leveraging its institutional and academic relationships to satisfy an array of strategic needs. The company focused on comprehensive solutions for engineering proprietary products, broadening institutional distribution, accessing capital, and aligning diverse entities to maximize market opportunities. Together DRI and Corridor successfully pioneered the new indices that help to enable derivative transactions on such spot market values.
From the outset DRI and Corridor focused on developing best of breed strategic relationships, and implementing a comprehensive business plan to bring these new products to market. They engaged MIT and Dr. David Geltner to create a proprietary methodology for the construction of the only transaction-based indices reflecting the cash prices of commercial real estate properties. MIT created 29 new indices delineated by property type and region. The indices utilize the transaction-based data from Real Capital Analytics, under exclusive license from RCA. The Corridor-DRI effort then licensed Moody’s-- the largest commercial real estate debt rating agency-- to calculate, publish and brand these indices, now known in the market as Moody’s/REAL Commercial Property Price Indices (“CPPI”).
CPPI indices are transactional, using a repeat-sales methodology. When compared to an appraisal-based index, a transaction-based index typically leads the appraisal index returns by several periods. Moody’s/REAL currently publishes 29 CPPI indices that cover each of the four major commercial property types: Office, Industrial, Multi-Family and Retail. The broadest of the CPPI indices is the National All-Property Index, which is updated monthly.
Finally, the tandem negotiated for State Street Bank to become the financial and infrastructure partner. A new venture was born: Real Estate Analytics LLC (REAL). REAL’s founders sold a majority interest to State Street. As such, State Street provides financial, custodial and other strategic services, including distribution for the indices and their related financial products.
REAL is now the real estate capital markets subsidiary of State Street Global Markets, and is commercializing and creating derivative products around a series of indices, including the CPPI and others.
Applications
The core uses for real estate derivatives are: hedging positions, pre-investing assets and re-allocating a portfolio. The major products within real estate derivatives are: swaps, futures, options (calls and puts) and structured products. Each of these products can use a different real estate index. Further, each property type and region can be used as a reference point for any real estate derivative.
The most basic form of real estate derivative is a swap transaction, in which one investor, or one side, goes “long” and the other side goes “short.” An investor would want to executive a swap if they thought that the market, or sector, was likely to appreciate, in which case they would go long. Alternatively, if an investor’s view was that the market would depreciate from that point, they would go short, or take the other side of that trade.
The market for real estate derivatives was long overdue. Real Estate is the only major asset class that only recently developed a derivatives market. According to the Pension Real Estate Association’s Plan Sponsor Research Report, pension funds allocate approximately 6.0% of their assets to real estate, making it one of the largest investable asset classes, after equities and fixed income. Because of the significant transactions costs involved with investing in real estate, derivatives can improve the efficiency of the market.
Derivative Efficiencies
Owning real estate assets is costly, and the transaction costs associated with purchasing commercial real estate can be prohibitive. Typical transaction costs can equal 500 - 800 basis points per transaction. Industry estimates suggest that transaction costs for commercial real estate easily surpass $10-$12 billion annually. Since the US real estate derivative market is new, the transaction costs are at this point variable. However, based on derivatives in other markets, it is anticipated that the costs will be well below the 500-800 basis points required to invest in actual, or “bricks and mortar,” real estate.
Market Growth
In the UK, the market for property derivatives did not begin until 2004. However, since the market’s inception, the growth has been significant. Through the third quarter of 2007, trades with an outstanding notional value of 7.9 billion pounds have been executed. The U.S. market is still emerging, and has been limited somewhat over the last year by the global credit crunch and uncertain values of mortgage-backed securities. However, the market in the U.S. is now emerging quickly, with over $500 million worth of transactions to date in 2007.
