Property derivatives are latest buzz

Real estate derivatives are destined to be either the latest hot investment or the next junk bonds, depending on whom you ask.

Still, a number of global investment managers, brokers and investment banks are developing real estate derivatives strategies, predicting the market could grow to $105 billion — from close to nothing now — in three to five years, Plus, new indexes are emerging in the United States to supply the statistical basis for them.

If the market takes off, derivatives could be a boon for money managers. The new strategy could also give investors a quicker way to invest their real estate allocations and to hedge the risk.

While the U.S. real estate derivatives market is in its infancy, the market in the United Kingdom ballooned this year to an estimated £3.7 billion ($7.26 billion) as of June 30, up from £927 million as of Dec. 31, 2005, according to a September report by data research firm Investment Property Databank, London.

Proponents say an active real estate derivatives market could help institutional investors reduce real estate portfolio risk, provide a new way of reducing or adding exposure to certain sectors and another way of investing in real estate without buying or selling buildings.

Not everyone is excited about the prospect of a new property derivatives market, though. Michael Dudkowski, vice president and consultant, Wilshire Associates, Santa Monica, Calif., argues that derivatives will be used for leverage on so-called "exotic debt structures," piling additional debt on instruments that could crash.

Wilshire Associates advises against using certain types of real estate derivatives, said Mr. Dudkowski, who works out of Wilshire's Pittsburgh office. "To the extent that real estate derivatives may be used to hedge against losses or time the markets, this runs contrary to our philosophy of following a long-term strategic exposure to the asset class.

"While some types of derivatives may be available to provide specific exposure to real estate … the marketplace for real estate derivatives is perhaps less developed than it is for other derivative types, and we would advise caution."

Others agree. "Who will back the trades and pay the investors the value of their investments when there is a market calamity that tests the new market?," asked Robert Kessler, chief executive officer of The Kessler Cos. Inc., Denver, an investment management firm.

Nevertheless, a number of recent developments are aimed at propelling real estate derivatives into a viable market.

In November, CB Richard Ellis, Los Angeles, and GFI Group Inc., New York, announced a collaboration to create U.S. property derivatives, said Phil Barker, vice president of real estate derivatives for GFI. The two firms already have a similar program in the United Kingdom.

In addition, the Chicago Mercantile Exchange is developing two real estate derivatives strategies. Together with Traditional Financial Services AG, a derivatives broker, Standard & Poor's and Fiserv Inc., an information management systems provider, the CME is developing the S&P CME Housing Futures and Options index. The CME also plans to launch a domestic commercial real estate derivatives strategy in the first quarter of 2007 — the U.S. Commercial Real Estate futures and options contracts — which will be based on commercial real estate indexes from Global Real Analytics LLC, San Francisco.

The key to establishing a successful real estate derivatives market is having enough trades to create liquidity for investors, said Mike Melody, vice chairman of CBRE Melody, New York, the mortgage brokerage subsidiary of CB Richard Ellis Group Inc.

So far, there have been very few trades in the U.S. because the National Council of Real Estate Investment Fiduciaries gave an exclusive license to Credit Suisse First Boston LLC, New York. Other investment banks refused to enter into derivative contracts because they did not want to enter into a deal controlled by a competitor.

In October, Credit Suisse First Boston waived the exclusive license it received last year to use the NCREIF Property index to create derivatives in order to stimulate a market. Now, NCREIF is free to license its index to other firms.

From the beginning the Investment Property Databank, which sponsors a property index in the United Kingdom that licenses derivatives, has been open to all takers, Mr. Barker said

Some 20 firms, including investment bankers Goldman Sachs & Co., Merrill Lynch & Co. and Bank of America Corp., are now in negotiations with NCREIF for a license, said Blake Eagle, chief executive officer of NCREIF. Most of the firms are U.S.-based, although some are European, mostly U.K. NCREIF officials are developing a standard licensing agreement.

U.S. institutional investors are showing some interest in using real estate derivatives strategies, Mr. Melody said.

"We have institutional clients we are regularly involved with, and there is a demand for additional risk management hedging tools in which they are giving up some upside potential but reduce the down side without selling off assets," Mr. Melody said. "They would be hedging volatility in the future by swapping certain real estate exposure."

These vehicles are not overly complicated but do require enough trades to create a level of liquidity, Mr. Melody said.

Larry Souza, chief economist at Global Real Analytics, said hedge funds, brokers and small retail traders are typically the first to invest in new derivatives, followed by pension funds and investment banks.

The U.S. derivatives market is estimated to grow to $106 billion in three to five years, according to the CME and Global Real Analytics.

A key requirement for a robust real estate derivatives market, however, is a reliable real estate index, as the bets made on the index are what determine returns.

Investment Property Databank's U.K. index is the index most often used for U.K. real estate derivatives because it is based on 11,000 transactions, said Peter Beckett, tax director for the real estate, hospitality and construction group of Ernst & Young U.K. LLP, London. A smaller transaction base skews the distribution of the index, Mr. Beckett explained.

"IPD is very well-respected. In the U.K., it represents 45% of the entire commercial property market," GFI's Mr. Barker said. In contrast, the "NCREIF (index) represents 5% to 7% of the property base."

The NCREIF Property index is based on quarterly appraisals and it takes one to two quarters for prices to show up in the NCREIF Property index, he added. The new U.S. indexes being developed for derivatives, such as Global Real Analytics' index, are based on property transactions. Industry executives say that creating transaction-based indexes that do not have the time lag of the NCREIF Property index is a step in the right direction.

The biggest traders in the U.K. derivatives markets so far have been hedge funds and institutions, including pension funds.

In the United States, pension funds are the largest investors in commercial real estate and could more easily attain their growing real estate allocation targets by adding derivatives, Mr. Barker said .