REIT and real estate derivatives are introduced as a new financial tool in the real estate world

By Dees Stribling

Someday soon, real estate investors will talk of going long or going short as often as they keep track of vacancy and absorption rates. Derivatives, an essential part of most other investment markets, are poised to become an integral part of the real estate marketplace.

Why has it taken so long? Modern derivatives, beginning with futures contracts on commodities, have been in the financial industry for many years now. "It isn't exactly clear why real estate derivatives are developing now rather than earlier, but it's probably due to a number of factors," says Phil Barker, vice president of derivatives for GFI Group, Inc., a London-based, inter-dealer brokerage, market data and analytical software provider for derivative markets. The GFI Group entered into a joint venture with CBRE-Melody to broker real estate derivatives in the United States in late 2006.

		The Swap Market Another emerging class of real estate derivatives involves swaps...

For one thing, recent market conditions may have slowed the development of real estate derivatives, Barker says. "Investors haven't seen a need for sophisticated risk management in recent years because real estate values have been consistently going up," he says, but that will not last forever. "Property owners are now beginning to appreciate derivatives as tools to manage their risk."

Managing risk is at the heart of real estate derivatives' appeal to investors. An investor who sells or "goes short" transfers the risk inherent in holding real estate to an investor more willing and perhaps more able to accept that risk and profit from it by buying or "going long."

"Real estate is the only major asset class in the world that doesn't have a supporting derivative market," Barker says. "Commercial real estate is valued at roughly $6 trillion in the United States, but there's never been a mechanism for managing risk, such as derivatives. In commercial real estate, it's traditionally either sell or buy and hold. But that's going to change."

Recognizing Real Estate Derivatives

Historically, commercial real estate deals have involved a considerable amount of complexity, time and expertise to negotiate, which are factors that served as barriers-to-entry into real estate. Also, direct real estate transactions can be opaque in terms of pricing.

In an established marketplace, derivatives have the advantages of liquidity and pricing transparency, Barker notes. "Derivatives introduce real estate to new classes of investors looking for hedge vehicles. Real estate wins exposure that it wouldn't otherwise be able to obtain," he says.

Real Estate Derivatives In the wider financial industry, derivatives have become an integral tool for investing in stocks, bonds and commodities over the last few decades. “Derivative” applies to a number of related financial instruments including futures, options and swaps, but in all cases it refers to assets whose value is “derived” from another asset or group of assets.

For instance, pension and hedge funds can use derivatives to hedge either property type or geographic risk, or to achieve for portfolio diversification that's easier and less costly than direct real estate investment. Lenders, such as banks and insurance companies, can use derivatives to guard against downside risk on their loan portfolios.

Derivatives offer hedging opportunities for real estate portfolio managers as well. In particular, portfolio managers can benefit from a derivative-enhanced yield by strategically selecting products based on property type or geography. Additionally, real estate derivatives can be used by developers to hedge development risk, or as a low-cost synthetic real estate investment for wealthy individuals, families and foreign investors, says Robert Ray, senior vice president of business development at the Chicago Board of Trade (CBOT).

REIT Futures

Once they're established, real estate index futures contracts will function much the same way as those tied to broader indexes, such as the S&P 500, according to derivatives experts. By shorting these kinds of contracts, investors can protect themselves from downside price risk in the REIT market.

Portfolio managers who are significantly invested in REIT stocks can also use real estate index futures to increase their exposure to movements within the index, in effect leveraging the portfolio. The real estate index futures market, like that of broader index futures, will probably evolve into a tool for price discovery of the underlying assets, once the market for the futures is active enough, Barker says.

In February, real estate-based futures trading reached a milestone when the Chicago Board of Trade—the place where futures contracts were first developed—launched its new futures contract based on the Dow Jones U.S. Real Estate Index (DJUSRE). As of March 31, 2007, the DJUSRE Index included 91 constituents, of which 85 were REITs. The DJUSRE Index futures contract trades electronically six days a week, and has a value equal to 100 multiplied by the value of the DJUSRE.

"We've talked to a lot of end users, and what we've heard is that it's time for derivatives to happen since real estate is a mature, institutional market," says Gene Mueller, managing director, financial instrument research and development of the CBOT, who adds there are two main groups interested in the product. "There are those who need to manage risk associated with REIT ownership, but there are also pension funds, wealth managers, family trusts and so forth, who want real estate exposure but don't want to get directly into the real estate game," he says.

As a tool of price discovery, Mueller anticipates that the market for DJUSRE index futures will be as useful as futures markets for other equities. "REIT securities often track the underlying U.S. commercial real estate market," he says. "REIT share prices are driven by factors such as lease rates, vacancies, development costs and property transaction values, all of which change rapidly and have a bearing on the index."

Innovative Products

When it comes to establishing a market for real estate derivatives, Susquehanna Investment Group, Wolverine Trading and Allston Trading currently serve as market makers for DJUSRE index futures. Their function is to provide a reliable two-sided market for CBOT market participants.

The CBOT's offering will not, however, be the only real estate index futures products. Others are in the works, such as one by the New York Mercantile Exchange (NYMEX) tied to the FTSE EPRA/NAREIT Global Real Estate Index. FTSE calculates and distributes the index and publishes it alongside a group of other indexes covering a variety of listed property stocks worldwide.

"There's a huge interest in this product," says Jerry Moskowitz, the FTSE Group's president and managing director for the Americas, "We've talked to a number of pension funds already, and they're keen to have the opportunity to hedge their risk with this kind of tool."

REITs will not, however, form the underlying basis of all real estate index futures contracts. After it introduced futures based on U.S. residential markets in 10 cities and one composite index in mid-2006, the Chicago Mercantile Exchange (CME) joined forces with Global Real Analytics, Inc. to launch a futures product based on the GRA Commercial Real Estate Indexes (CREX) last fall.

Ten different commercial real estate futures contracts will be available once trading begins later this year. These include a composite index, an index for each of the apartment, industrial, office and retail property sectors, and one for each of five geographical sections of the United States. The CME expects these products to attract new investors into real estate.

"The development of commercial real estate indexes fits into our strategy to attract new users to the market," says Rick Redding, CME's managing director for products and services.

What's Next?

Now that real estate derivatives have been introduced, industry experts are predicting what's next for the financial tool. "There still are some obstacles in the development of derivatives in the private equity sector," says Scott Booth, a consultant with The Townsend Group. "Perhaps the main one is the lack of market makers. However, it's reasonable to expect further developments in derivative products for private equity real estate, since the real estate industry is recognizing the benefits and will overcome these current difficulties."

FTSE's Moskowitz says that the use of real estate derivatives is just getting started. "I predict that in 10 years, they'll be standard in the industry, with numerous products available." The potential advantages of real estate derivatives are now more widely acknowledged in the real estate industry than only a few years ago, he adds.

Barker agrees, citing the rapid recent growth of total return swaps in the United Kingdom as a possible precursor of what might happen in this country. Commercial real estate interests on this side of the pond have been watching with interest the growth of British real estate derivatives, which began in earnest in 2005, when trading volume in derivates based on International Property Database indexes spiked from £260 million in 2004 to about £840 million. In 2006, volume was about £3.5 billion ($6.8 billion).

"It started with only international banks involved at first, but the end users are finally getting involved," Barker says. It has become accepted in the United Kingdom as a mechanism to manage real estate portfolio risk, and the market is set to expand quite dramatically in the United States as well."