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Creating a New Calculus

Commercial real estate is about to become the latest sector subject to the world of derivatives, those mind-bending financial instruments that are calculated based on an underlying asset's value, but don't involve actually buying or selling that asset.

Four different indices have been introduced and are being fine-tuned, all calculated based on distinct formulas and disparate pools of commercial property. All are hoping to be the benchmarks that derivatives traders use to forge agreements in which they swap money or assets based on the performance of commercial real estate.

The backers of these indices — formidable forces like Standard & Poor's, Real Capital Analytics and the National Council of Real Estate Investment Fiduciaries (NCREIF) — are also hoping to entice a new class of investors into the real estate fold, ones that have no interest in owning property directly or investing in REITs. If these groups have their way, investors will soon be juggling synthetic portfolios of real estate and making money based on changes in property values, rents or sales volume — depending on how you structure your trades.

A recent survey conducted by the Pension Real Estate Association (PREA) found that 15 percent of its members are giving serious consideration to using derivatives.

There's just one catch: no one seems to want to be the first kid in the pool, says Louis Wolfowitz, managing director of capital markets for New York City-based Cushman & Wakefield Inc. “When we talk to clients, they say it's interesting and to let them know when the market becomes liquid,” he says. The biggest concern right now is pricing and market liquidity, says Jim Clayton, director of research at PREA. “Everybody expects the derivatives market to happen, but they don't want to get involved until the market has been established.”

The movement to launch commercial real estate derivatives began two years ago. Then, NCREIF licensed its National Property Index to Credit Suisse. The index, dubbed the NPI, is already a widely used benchmark for commercial property returns in the United States. Credit Suisse then took on the project of figuring out how to build a derivatives market from that. But the project had trouble getting off the ground. Some experts say forging an exclusive relationship with Credit Suisse was a mistake. It hindered the growth and development of a derivatives market because it prevented any competition among investment banks and other players. Without that competition, the index failed to gain any traction.

Last year, however, Credit Suisse relinquished its exclusive license. Immediately, seven other investment banks jumped to sign on with NCREIF including Banc of America, Goldman Sachs and Merrill Lynch. As a result, at least a few derivative trades have occurred, according to Phil Barker, vice president of real estate derivatives for GFI Group Inc. Now other forces are aligning and forming their own indices, with the hope that it will help commercial real estate derivatives gain traction.

There are some precedents that backers of a U.S. derivatives market can learn from. Ian Cullen, Ph.D. and founding director of the London-based Investment Property Databank Ltd. (IPD) created a commercial real estate index for derivative trades in the United Kingdom and has been on the ground in the U.S. for the past two years scouting opportunities and trying to educate interested parties. “I am sure the market in the U.S. will grow quickly now that banks and investors have learned about derivatives in the United Kingdom and are able to export that knowledge,” Cullen says.

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 U.K. action helped breed a French spin-off based on the IPD index of property in France.

However, there are very real difficulties in the United States that the United Kingdom hasn't experienced. In the U.K. investors have embraced the IPD index as the sole benchmark. In the U.S., however, several indices are vying for that distinction.

The NPI is at the forefront because it is already recognized by institutional investors. However, many industry players are debating the veracity of the NPI. It only covers about 7 percent of the total commercial property inventory in the United States. (For example, owner-occupied and REIT properties are not included in the NPI.) Moreover, the assets are not appraised routinely, which means the indexes may not accurately represent current valuation.

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 the Massachusetts Institute of Technology Center for Real Estate; and the Rexx Real Estate Property Index, which includes backing from Cushman & Wakefield and Newmark, Knight, Frank. While the SPCREX and RCA indices are both transaction-based, SPCREX is based on average sales price per square foot and RCA's indices are derived from repeat sales of properties in a transaction database. The Rexx Index, meanwhile, is based on metropolitan area office rents. (See box below.)

Long and short of it

Experts are split on whether the development of competing indices will help or hinder development of the market. PREA's Clayton says the presence of multiple indices is positive because investors can choose derivative strategies based on the index that best suits their specific situations.

But, others think multiple indices harm the market in the long run. “For a derivatives market to work, traders have to be focused on the same index,” says David Geltner, Ph. D., professor of real estate finance and director of the MIT Center for Real Estate.

For its part, GFI is a big believer in the derivatives industry. It partnered with CBRE Melody, the mortgage brokerage subsidiary of CB Richard Ellis, to broker real estate derivatives in the United States to investment banks, hedge funds, pension funds, endowments, insurance companies and other institutional investors. (The two firms launched a similar initiative in the United Kingdom in 2005.)

“We sense that the growth level will be exponential and very fast,” Barker says. “It's early, but given the size of the commercial real estate market, the commercial property derivatives market could be worth billions.”

It could be even bigger, Geltner predicts. He estimates the annual trading volume for a fully formed commercial real estate property derivative could reach $1 trillion. That assessment may be a bit optimistic, given that residential real estate derivatives — launched for the same reasons as commercial real estate derivatives — have been a slow to catch on.

In May 2006, the Chicago Mercantile Exchange began listing futures contracts based on the Case-Shiller/S&P repeat sales house price indices at the national level and ten major metropolitan areas. Approximately 340 million dollars' worth of derivatives contracts traded on the CME in 2006.

“The market is growing but far more slowly than I had hoped,” says Jonathan Reiss, manager of Analytical Synthesis LLC, a New York City-based financial consultant. “New markets have a problem reaching critical mass until there's liquidity in the market. It's the chicken or the egg conundrum.”

Still, Wolfowitz says derivatives could become a great tool for institutions to gain exposure to sectors or markets without investing directly in real estate. If, for example, a pension fund is over-allocated to real estate because of the run-up in values, it can hedge against that concentration risk by swapping the real estate return for another type of asset by buying (“going long”) or selling (“going short”).

Using a derivative “swap,” an investor can get in and out of real estate very quickly. “It's cheaper and more efficient to manage a synthetic portfolio,” says Neal Elkin, executive vice president of Real Estate Analytics LLC, an affiliate of Real Capital Analytics that has created its own set of indices.

This type of derivative is useful when an investor is focusing on a specific property type or a particular region. For example, investors that wanted to buy into superregional malls only had the option of purchasing regional mall REIT stocks in the past. “Investing in the REITs only gives you the performance of the companies and their stock, it doesn't give you the actual returns of the mall properties,” says Doug Poutasse, executive director of NCREIF. “With derivatives, an investor can buy a regional mall subindex.”

And using derivatives as a hedge is not a strategy limited to investors. Tenants can also take advantage of them. For example, a 500,000-square-foot tenant in a Midtown Manhattan office building concerned about rising rent can play the income portion of an index. If rents go up, the derivative position has increased in value and makes up for the increase in real rent they are paying.

However, you need someone on the other side of the trade for derivatives to work because there's no up-front money involved. Investors whose trades pay off receive a total return from trading partners based on LIBOR plus a small spread.

However, derivatives work best for investors with large portfolios. “If you're a smaller investor, you can take the short side on the index, but nothing says that your particular building will be offset by the index,” says Richard Buttimer, professor at Belk College of Business at the University of North Carolina. “Unless you're diversified, you might not get the benefits of hedging.”


National Property Index

  • Derived from institutional class properties owned by investment managers and pension funds, but not REITs
  • Quarterly un-leveraged returns (total, income and appreciation) at the national, regional and metro-area level by property type back to 1978. Based on appraised values. Tends to lag “true” market returns due to the nature of the appraisal process
  • Comprised of about 5,000 properties, which represents only about 7 percent of the entire real estate market
  • Benchmark for most institutional core real estate portfolios

Real Estate Analytics Indices

  • Created through partnership with Real Capital Analytics and the MIT Center for Real Estate
  • Monthly price indices and capital returns at the national level back to 2000, quarterly indices for core property types and annual indices for select MSAs
  • Transaction-based: Constructed using a statistical/econometric methodology applied to repeat sales of individual properties
  • Similar to methodology used to construct the Case-Shiller/S&P housing price indices that are traded on the Chicago Mercantile Exchange

REXX Index

  • Cushman & Wakefield and Newmark, Knight, Frank are minority owners and data contributors
  • Quarterly returns (total, rent and capital) at the national level as well as for 15 major metro areas back to 1994
  • Office only at the current time
  • Proprietary model based on current micro (space market) variables, including rents, vacancy rates, and leasing activity and macro variables such as interest and inflation
  • Metro-level rent focus allows investors to hedge on performance in specific local markets

Global Real Analytics Commercial Real Estate Index (SPCREX)

  • Quarterly price indices and capital returns at the national and regional level as well as property type on a national basis, back to 1994
  • Transaction-based: Price index is derived as the three-month moving average of average sales price per square foot. Average sales price per square foot figure is derived using a proprietary algorithm applied to property-level transaction price per square foot data observations

Source: Pension Real Estate Association

How It Could Work

Big City Employees Fund is a pension fund that has $150 million in stocks and $150 million in long-term bonds. The Fund decides that it wants to diversify its portfolio by investing one-third of its total funds in each of the following: stocks, bonds and real estate.

But the Fund isn't big enough to create its own real estate portfolio. It instead participates in a commercial property capital-return swap through a three-year contract based on the Real Estate Analytics LLC index. The market for such swaps offers pricing that will pay the investor the price-index return plus 15 basis points per month. The Fund could place $100 million into derivative swaps, which require no cash outlay up front, as it is a futures contract.

Each month for the next three years the Fund will then receive the Index return, which equals 2 percent per year, plus the 15 basis points per month payments. Total return: 7.8 percent per year. — JP

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