A Synthetic Strategy to Hedge on Real Property

Welcome to the brave new world of U.S. commercial real estate derivatives.

On Friday, Credit Suisse executed the first licensed property derivatives transactions tied to the NCREIF (National Council of Real Investment Fiduciaries) Index. This marks the first time that the NCREIF index—a benchmark of 4,718 U.S. commercial properties worth roughly $189 billion—has been used to structure licensed derivatives contracts for real estate investors.

Derivatives contracts allow investors to acquire stakes in the real estate market without actually buying any real assets. In this case, they will enable investors to hedge their exposure to commercial real estate. Derivatives are contracts whose values are based on the performance of an underlying financial asset, in this case the NCREIF Index.

The 24-year old index publishes performance data on its member properties every quarter. In 2005, the NCREIF Index posted total returns of 20.06%. A full 6.75% of that total was income-based, with the balance coming from appreciation.

“Up until now, the only way to hedge on real estate was to sell it,” says Jeffrey Altabef, a managing director in real estate finance and securitization at Credit Suisse. “But that’s not acceptable to many long-term investors. What we’ve created here is a synthetic way to hedge your risk by shorting the value component.”

The new instruments are aimed at managers of mushrooming institutional real estate portfolios, which Credit Suisse sees as a significant untapped opportunity for sophisticated risk-management products.

There’s every reason to believe Credit Suisse is right, too. Institutional investors poured $51 billion into commercial properties last year versus $44 billion in 2004, reports Kingsley & Associates. The consulting firm projects that institutional capital flows into real estate will hit $59 billion in 2006.

Altabef declines to name the investors involved in the first transactions, but says that each has extensive real estate holdings. One of the recent transactions involved a real estate fund attempting to hedge its exposure to the apartment sector, while adding exposure to the office sector.

Using four property-type sub-indices, the NCREIF Index can be played in several ways to provide short and long bets. In the January deal, the real estate fund entered into a swap agreement to receive the total return on the NCREIF Office Index while paying the total return swap on the NCREIF Apartment Index. The $10 million transaction was structured as a two-year trade.

“We believe derivatives will add liquidity and transparency to the institutional investment market for commercial real estate,” says Blake Eagle, chief executive officer of NCREIF.

Why has it taken this long for a U.S. property-based derivatives market to emerge? Doug Poutasse, chief investment strategist at real estate advisory firm AEW Capital Management, says it’s because most real estate investors crave real property and simple capital appreciation. In recent years, he notes, there has been no reason to think outside that box.

But, as the boom cycle stretches into a fifth year, hedging looks like an attractive precaution. “Someone will make lots of money if the property markets tank,” says Poutasse, who helped devise the NCREIF index back in the early 1980’s. “People have wondered for years how the property markets can keep strengthening every year, and nobody thinks it will last forever.”

Poutasse agrees with Eagle of NCREIF that the emergence of a derivatives market bodes well for the market in general. First, it allows investors to buy stakes in the real estate market without buying individual assets or funds—and that boosts liquidity. And, he says, it will add transparency by drawing more attention to the NCREIF Index and likely pressuring NCREIF to include more member properties on the index.

One possible hitch in this scenario is the difference between NCREIF, which is based on actual properties, versus indices that are based on corporate assets. “The NCREIF Index is to real estate what the NYSE composite index is to stocks,” says Poutasse. “So one issue that NCREIF may run into is that derivatives investors will probably want to be swapping something that is fixed.”

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