Property derivatives have been promoted as a revolutionary tool for real estate portfolio risk management. Frédéric Ducoulombier argues that this is a misguided approach that obscures the key benefits of these instruments.
Commercial presentations have touted the benefits of property derivatives as risk management tools for real estate portfolios. GRA (Global Real Analytics), for instance, maintains that futures and options on its indexes "will have a significant impact on how investors hedge and participate in real estate", and its partner CME (Chicago Mercantile Exchange) judges that such products "promise to provide readily tradable risk-shifting tools". This article introduces property derivatives and hedging, points out the specificities of the real estate market that impact an investor's ability to hedge with index-based products, and looks at the empirical evidence that can help predict hedge effectiveness in the real estate market.
Currently, the commercial property derivatives market consists almost exclusively of total return swaps (TRS) involving the IPD UK indices. Investors can gain or increase exposure to the UK commercial real estate market by swapping a fixed or floating rate against the return on the index; investors seeking to reduce exposure or establish a negative exposure will do the reverse. A typical swap sees the buyer (seller) of real estate exposure pay (receive) LIBOR+spread in return for the total return of the IPD All Property Annual Index. The notional amount of the transaction is used to compute the contractual obligations, which are then swapped; the principal notional amount never changes hands, thus greatly limiting the impact of a default. The use of a highly creditworthy intermediary as a counterparty in every transaction further mitigates credit risk.
The operation closely resembles a physical property transaction financed entirely by debt since the buyer in essence borrows at LIBOR+spread and receives the total return from the property. Derivatives promoters stress this similarity to the physical market as well as the advantages of derivatives over bricks-and-mortar transactions: no stamp duty or legal and agent fees, ease and swiftness of transaction, no exchange of principal or immediate exchange of cash flows, no need for the buyer to deal with physical asset management, the covered seller's retention of ownership and operational management.
Promoters of real estate derivatives assert that index derivatives can be used to neutralise a portfolio's exposure to real estate market risk (or beta) so that it delivers only specific performance (or alpha). However, brochures rarely comment on the relative importance of market risk on the returns of portfolios representative of the real estate holdings of their targeted institutional clientele. Hedging strategies are typically either only alluded to or simplistically illustrated. A recent research note on property derivatives prepared by a leading bank provides an illustration of "efficient hedging between portfolio and index return" that sees a manager of a €10m portfolio who has observed an 85% correlation with its country index transact in a TRS to hedge against a fall in the market. The note assesses the impact of swapping the index return against a fixed rate, using a one-for-one hedge, by looking at TRS payments and overall returns from the hedged vs non-hedged portfolios over the life of the swap. It considers only two states of nature: a baseline scenario where the return of the hedged portfolio is only slightly less than that of the non-hedged position and a "risk" scenario where the hedged portfolio is much more attractive. An equal weighting of the two scenarios results in a "marked reduction of risk" and the note concludes that "this effect is of major importance especially to institutional investors who have held out the prospect of a minimum return to their clients."
When the asset whose price fluctuations are to be hedged is not exactly the same as the underlying of the derivatives contract or when the contract expiry date does not coincide with the execution date of the spot transaction to be hedged, basis risk - cross-hedge basis risk and time-basis risk - reduces hedging effectiveness. Analysing the correlation between the values of the position to be hedged and the prices of the available derivatives can help determine the contract(s) to be used for hedging.
Derivatives markets are far from complete and managing the price risk of an asset on which no contract is available will require cross-hedges involving close or not-so-close substitutes. Instead of finding a substitute with a high correlation to the asset, the investor could identify the fundamental sources of risks driving asset returns and then hedge price risk with derivatives proxying for each of these. Risk not explained by fundamental factors - if not a result of factor omission or model mis-specification - is specific to the asset and cannot be hedged; in a portfolio context, however, it is diversifiable. Diversification refers to the allocation of monies to different individual assets or asset classes.
When less than perfectly correlated assets are grouped together in a portfolio, its total risk is less than the weighted average of the total risk of its components. A well-diversified portfolio has total risk that is reduced to the average exposure of component assets to the same common sources of risk; it has no specific risk left. The more individual assets are driven by common factors, the easier it is to build a diversified portfolio that tracks the market.
The less common factors affect asset returns, the more diversification has to offer in terms of risk reduction but the more difficult it is to build a diversified portfolio.
Diversification is so easy on the listed equity market that it has led to a pricing paradigm, the Capital Asset Pricing Model (CAPM), which states that only non-diversifiable or systematic risk is rewarded. According to the CAPM, there is no compensation for asset-specific risk and, in the portfolio context, the risk of an individual asset is assessed by its exposure to the fundamental sources of risk affecting the market as a whole, which conveniently collapse into the normalised covariance between the returns on this asset and those of the market portfolio. In practice, the latter is proxied by a composite equity index. Wide acceptance of the CAPM gave rise to stock index derivatives allowing the transfer or hedging of the non-diversifiable market risk.
While the CAPM is based on many unrealistic assumptions and does a poor job at describing security returns, empirical evidence supports the market index vs specific risk decomposition of individual equity variability.
Brown and Matysiak (2000)1 find that the stock market explains about 30% of the variation of an individual stock and that it takes on average 44 stocks to diversify 95% of the specific risk. They observe strikingly different results for real estate, where the market factor explains only 9% of the risk of the average monthly valued property and it takes an equally weighted portfolio of 171 properties to achieve 95% diversification. Unlike stock companies, properties are not divisible, making equal weighting impossible and diversification difficult. Besides, it is not possible for an investor to hold the average portfolio, and diversification of any portfolio of 44 stocks could be significantly larger or lower than 95%. So, 95% diversification - with little margin for error - of an individual real-estate portfolio would require hundreds and possibly thousands of properties.
Several observations are in order:
To hedge the market risk of a portfolio with index futures contracts, the optimal position to minimise the volatility of the hedged position can be shown to be:
h = _RP, RM._RP / _RM = √R2._RP / _RM = _RP, RM/ _2RM = _RP
The number of contracts to hold to offset the market risk in the portfolio is then given by: h or _RP times the ratio of the value of the portfolio to the nominal amount of the contract. Note that the naive one-for-one hedge is obtained only when the correlation between the port-folio and the index is equal to _RM / _RP or, equivalently, when the slope of the regression of the portfolio returns against the index returns is one. The hedge ratio is directly positively linked to the importance of the market factor as an explanatory variable of portfolio variability. A 2007 IPF report looked at the question using a sample of 1,700 properties from the IPD UK universe over the period 1994-2004 (table 1). Using IPD properties, the study upwardly biases correlations with the IPD index, resulting in an upward bias of the importance of the market factor (R-square) and in a downward bias of the average tracking error: tracking the IPD index with properties that are not part of it will be harder. The figures above nevertheless suggest that most portfolios will be poorly correlated with the index - assuming a conservative average commercial property value of €75m, it would take approximately €3.75bn of IPD properties to establish, on average, a portfolio which could be effectively hedged with an IPD derivative (a R-square of 80% is traditionally considered the threshold for hedging effectiveness); at this level, a 2% deviation of the portfolio vis-à-vis its benchmark would still occur at least once every three years, and a 1% deviation almost two years out of three.
As a result, index property derivatives will be poor hedging instruments for all but the largest portfolios of direct commercial real estate. For direct investors in property, hedging-related demand for derivatives could be limited to the major real estate investment managers and trusts. Indeed, a €10m bricks-and-mortar real estate portfolio with an 85% correlation to the market index will be as hard to find as the proverbial needle in a haystack. The difficulty of replicating a non-investable index such as the IPD All Property also casts doubt on the validity of prices at which derivatives are transacted, since pricing by arbitrage is not feasible.
While the risk management argument has taken centre stage in the promotion of property derivatives, the specificities of the class render hedging with index-based derivatives ineffective for all but the largest traditional real estate investors. Therefore, when marketing to investors holding physical real estate, brokers and investment banks should probably emphasise the remarkable diversification benefits of index-based investments. To investors in search of alternative beta and new tools for alpha generation, property derivatives provide a rather liquid synthetic exposure to the commercial real estate market, exposure that allows the use of a range of familiar investment and arbitrage strategies unavailable in the physical real estate market.
However, derivatives written on non-investable property indices may be both expensive and mispriced as index-tracking challenges limit arbitrage activities between derivatives and the underlying physical markets. A closely related issue is the high volatility observed on existing contracts: marking to market a fund investing via IPD swaps could result in asset value fluctuations far more severe than those observed on the underlying market.
1 Brown, Gerald R & Matysiak, George A (2000), Real Estate Investment: A Capital Market Approach (FT Prentice Hall)
Frédéric Ducoulombier is associate professor at the EDHEC business school in Nice