What if institutional investors, while increasing their allocations to both residential and commercial mortgage-backed securities, had been able to hedge their exposure to the underlying collateral?
The stock of U.S. commercial real estate has seen nearly $800 billion in paper losses as of Sept. 30, as measured by the Moody's/Real Commercial Property Price index, since the peak of the real estate boom on Oct. 1, 2007. Institutional investors could have mitigated this shift by using tools such as new property derivatives that can hedge risk during periods of significant volatility.
The Moody's/Real Commercial Property Price index, which measures changes in actual transaction prices for commercial real estate assets, showed an 11.2% decline in the value of commercial real estate worldwide for the year ended Sept. 30. The S&P/Case-Shiller Home Price index, a leading national measure of composite home prices was down 16% over the same period. If an investor had gone short on either or both of these indexes a year ago, they would have protected themselves from deterioration in value of the collateral backing their bonds.
Prior to the advent of these indexes and derivatives based on them, institutional investment in real estate had mostly been a one-way bet. Investors with views about real estate could express neutrality by not investing or could take what could be a rather illiquid long position by purchasing brick-and-mortar or shares in a real estate investment trust.
But the rigidity of these investments makes them less than ideal for inclusion in a broad, flexible portfolio. When real estate markets have turned down, as they inevitably will given normal market cycles, the only means of raising cash and mitigating against losses has been to sell physical property into the declining market a disastrous turn of events for both the investor and the market.
Historically, institutional investors have been underexposed to real estate. While real property accounts for more than 40% of the U.S. capital market investment, most pension funds limit direct investment in real estate to single-digit percentages. One reason for this might have been the lack of hedging tools to mitigate exposure. Only now, with the advent of real-time, transaction-based indexes, can we calculate what this allocation has cost in terms of suboptimal allocation returns.
An important characteristic of real estate investing is that it has not historically been indexed in any meaningful way. Investment in MBSs and REITs exposed investors to a narrow band of risk, without a broad, countervailing hedge. These investments took place in the absence of viable national indexes capable of supporting derivative contracts with minimal underlying basis risk.
But, in recent years, new U.S.-based indexes such as the Moody's/Real Commercial Property indexes; the FTSE NAREIT U.S. Real Estate Index Series of the National Association of Real Estate Investment Trusts; and the NCREIF Property index of the National Council of Real Estate Investment Fiduciaries have been published to articulate price changes in a broad swath of real estate markets and submarkets.
These new indexes allow for the creation of wide-ranging derivative that for the first time allow institutional investors to hedge their exposure to commercial real estate. So derivatives of the indexes trade over the counter. These tools can be used not only to rebalance portfolios and mitigate risk but to selectively identify and capture alpha opportunities. Institutional investors have definitely not taken full advantage of this innovation, and this sector remains in its infancy.
Over the long term, these new instruments may facilitate more optimal portfolio allocation for investors. Even more importantly, they may bring a better, more sustainable balance into the relationship between commercial real estate and the overall capital market investment.
If investors with leveraged exposure to real estate assets via direct investment, e.g., commercial and residential buildings, or via REIT and MBS investments had used the growing residential and commercial property derivative market, they could have mitigated their own portfolio risk while at the same time creating more balance with long investors mirrored by those shorting the real estate asset class.
Neal Elkin is president of New York-based Real Estate Analytics LLC, a division of State Street Global Markets LLC, a unit of State Street Corp., Boston.