US investor scepticism towards property derivatives has prompted a new educational initiative. Jim Clayton reports
One of the more interesting and exciting recent developments in institutional real estate, both in Europe and the US, is the emergence of property derivatives markets. Real estate is the last major asset class without a significant derivatives market. It seems to be a natural next step in the evolution of real capital markets, transitioning from a private asset class characterised by high transaction costs and the inability to sell short, to one with significant financial market integration, and the associated fast pace of innovation, price discovery and market pricing.
Property derivatives represent a new way for investors to gain or reduce exposure to the real estate asset class, or parts of it, quickly and without directly buying or selling properties, but instead the performance of a real estate return index via a swap contract. The speed and ease of execution, reduced upfront capital requirement and ability to protect real estate portfolios on the downside provide added flexibility in executing real estate investment and portfolio risk management strategies.
The market for commercial real estate (CRE) property derivatives has gained significant traction in the UK over the past two years. The US market, however, has been slower to develop. Many investors are indeed watching with interest to see if this new way to invest in and hedge private real estate risk will materialise and revolutionise the institutional real estate world, as it has in stock and bond markets around the world. However, to this point investor interest has not translated into the kind of trading volume in the US that many thought would have transpired after Credit Suisse relinquished the exclusive licence it received from the National Council of Real Estate Investment Fiduciaries (NCREIF) in 2006, and NCREIF subsequently began licensing its indices in March of last year for derivatives trading on a non-exclusive basis. This is more along the lines of the successful model adopted in the UK, where the property derivatives market has witnessed rapid growth and development over the past two years.
While many are excited about the new investment and risk management possibilities offered by property derivatives, others are sceptical about investors' willingness to embrace these new tools. Some institutional investors in the US have shown a reluctance, or at least hesitance, to even consider the potential use and application of index return swaps as part of the real estate strategy. There is concern among some that trading by non-traditional real estate investors with a short-term focus (eg, hedge funds) will add volatility to and potentially destabilise the private property market. To these market participants real estate represents a tangible bricks and mortar asset, whereas derivatives are seen as complex financial instruments created by Wall Street investment bankers. So is there really a need for commercial property derivatives?
What are the implications of growth in real estate derivatives for investment in traditional real vehicles?
To help answer these and other questions, and foster the development of the CRE derivatives market in the US, a new industry group has been established. The Real Estate Derivatives Special Interest Group (RED-SIG), will offer insight and perspective on the use, applications and implementation of commercial property derivative products. The group is initially focusing on NCREIF-related derivative products. A major goal of RED-SIG is to bridge the knowledge gap that exists between traditional real estate players and the Wall Street derivatives world, as well as the gulf between theory and practical implementation.
RED-SIG has established an advisory group that includes institutional investors, portfolio managers, index providers, academics, tax advisers, banks and brokers. The group's website site, www.red-sig.org, provides the names and links to founding members, a section on FAQs that the group is working on providing answers for, reference documents, as well as other resources on the evolving US, UK and continental European real estate derivatives markets. Specific questions and issues the group is working to address currently include: valuation and accounting practice for index swaps, the potential for unrelated business taxable income issues for tax-exempt US investors, and the applicability of the Foreign Investment in Real Property Tax Act for investors entering into NCREIF-based swap contracts. The website also has links to summary data for price quotes on NCREIF swap contracts.(1)
The formation of RED-SIG is an important step in the development of the US derivatives market and borrows from the UK experience, which clearly illustrates the crucial role of continued education and collaborative information exchange in developing a successful CRE derivatives market. The efforts of the Property Derivatives Interest Group of the Investment Property Forum, and its predecessor, the Property Derivatives Users Association, have been extremely beneficial in the UK. The hope is that RED-SIG will have a similar outcome in the US.
Note: This article reflects the personal views of the author and not necessarily those of PREA or other RED-SIG members. The advisory group is a cross-industry group working together to facilitate the exchange of information.
(1) On 2 January 2008, the credit derivative data firm Markit began acting as the calculation agent for total return swaps on select NCREIF property indices. Closing levels are published by 4:30 PM each business day at: http://markit.com/information/products/category/indices/NCREIF.html
Jim Clayton is director of research, Pension Real Estate Association (PREA)