Real estate as an asset class
The real estate market as a whole is an aggregate of many submarkets such as owneroccupied housing, offices or land. Usually the performance of a submarket and not the overall market is the focus of an investor. It is important to take indices as underlying instruments that have a large community of potential users. Primary users are generally institutional investors, but private investors should also be able to understand and benefit from property derivatives.
While investors see real estate as an asset class that must generate a return as high as possible, homeowners see their house as a consumption good with some price risk. The submarkets for the two are completely different. The choice of an index as a suitable underlying instrument for derivatives depends mainly on the criteria of the region, property type and data base (rents, transaction prices or appraisal values). Types with a potential volume that is sufficiently large for a reasonable derivatives market include offices, residential properties, retail space and industrial space. It is doubtful whether more special property types such as hotels or even land would find a big enough market.
Owner-occupied housing is treated very differently around the globe. While homeowners borrow relatively moderately and stay for decades in their home in central Europe, households in the UK and in the US are much more sensitive to property price movements. Often, they are ready to realize gains by selling their home or they increase the mortgage once prices have appreciated.
Only the latter mind-set may lead to a broadly supported desire for protection against falling house prices. The market for owner-occupied housing is huge, and the sufficiently large number of transactions make indices more reliable.
The credit and tax bindweed on the growth
In 2004, the authorities loosened the legal and tax bindweed on the growth of a wider derivatives market. One of the earliest derivatives swap was arranged between Deutsche Bank and Eurohypo in 2005, and brought together a buyer and a seller of UK property risk. The seller exchanged a total property return (based on the IPD Index) for a LIBOR-based return paid by the buyer based on a notional principle. Prudential, the UK life assurer, and British Land also agreed on a commercial property swap at about the same time.
The formal launch of the Property Derivatives Interest Group (PDIG) on 16 September 2005 has set the crucial signal for the property market in the UK, which may serve as a role model for property derivatives trading elsewhere. However, the UK is somewhat fortunate because the available indices that are run by IPD are mature and widely accepted as accurate. That is not (yet) the case in most other countries.
In 2006, the market could build on the growth of the previous year and attracted further investment banks. Several banks started to quote option prices on IPD’s main index. Further, it was hoped that the arrival of sectoral transactions would deliver a further boost to the market. However, after a few trades on sector and even subsector indices in 2006, there were no more such deals in the first half of 2007. In essence, it remained a simple swap and forward market on the All Property Index with a few option trades, before trading volume soared in the wake of the US subprime mortgage crisis. The uncertainty introduced by the crisis attracted a number of new participants in the property derivatives market.
Payday loans to build exposures to different markets
Throughout the 1990s, several other initiatives were launched to get derivatives started. Iain Reid, a property consultant, realized that property funds could benefit hugely from the ability not just to build synthetic exposures to different segments of the market but also to hedge existing long positions by creating off-setting short positions. Reid moved to Barclays and found that its bankers were similarly enthusiastic about his plans to develop a product that could hedge property exposures. The UK real estate market had just been through a crash, and Barclays had property exposure as a result of bad loans made to property developers. To them, the idea that they could hedge that exposure was a revelation and they were very keen to launch something.
Together with Aberdeen Property Investors, Barclays Capital structured a tradable bond that pays out IPD index returns. They called these bonds Property Index Certificates (PICs). PICs link their coupon payments to the IPD All Property Income Return Index and the capital redemption value to the IPD All Property Capital Growth Index. Investors who wanted to gain exposure to the property market paid upfront to buy the bond and received income based on property valuations in the form of quarterly coupon and redemption payments. By issuing PICs, Barclays basically exchanged its long property exposure for a fixed income. The PICs were seen as bond instruments that pay a return based on an IPD index rather than pure derivatives.
The instruments enable investors to bet on the market, but not against it. Since its release, the certificate has mainly created interest from high-net-worth, private bank and institutional investors. In addition, Barclays launched exchange-traded Property Index Forwards (PIFs). These forward contracts on the IPD Capital Growth or Total Return Index included some standardized elements, to make the products tradable. However, in contrast to exchange-traded future contracts, not the market itself but the bank took the role of the market maker. Since the bank never really succeeded in developing a liquid secondary market, the concept was still based on matching buyers and sellers. Barclays continuously quoted prices for the contracts.
The Credit Property Total Return Swap
By December 2007, property derivatives deals have been made public in Australia, France, Germany, Hong Kong, Italy, Japan, Switzerland, the UK and the US. Deals were referenced to both commercial and residential properties. Derivatives that reflect commercial real estate are typically tied to appraisal-based indices while derivatives that reflect owner-occupied residential housing usually use transaction-based indices as the underlying instrument (see property indices).
Most contracts are still executed as matched bargain trades between a buyer and a seller, with pricing determined through negotiations between them. As the market becomes more liquid, standardized contracts will become available directly from intermediaries. They will price the contracts and assume the risk of finding a suitable counterparty.
Several derivative structures have been developed and traded. So far, the bulk of trades has been structured as over-the-counter (OTC) swap contracts. In addition, a few derivatives are listed and traded on public exchanges. Most market participants are aiming to create derivatives that replicate the familiar characteristics of direct property investment, i.e. quarterly rental income and annual capital growth. As the market expands, the variety of structures increases. Derivative markets have a particular order of development and it is not unusual for options to develop after futures and swaps, because the option writers require these instruments to be liquid in order to hedge their positions.
The Property Total Return Swap (PTRS) is the most popular format and, in principle, swaps a fixed or floating interest payment for an amount calculated with reference to total returns on the property index, which consists of both rental income and capital gains (see swap transactions). The swap structure is quite simple and the variations usually only involve the choice of the index (country, sector and rental, and/or capital growth index), the tenor and the payment conventions.
Median prices of home credits
The Chicago Board of Options Exchange (CBOE)’s Future Exchange (CFE) offers futures contracts that track prices nationally and regionally (North-east, South, Midwest and West) and eventually in 10 metropolitan areas as well.
CFE contracts are linked to the median price of existing home sales as tracked by the National Association of Realtors (NAR). Further, HedgeStreet allows anyone with a US$ 100 deposit and an internet connection to trade financial instruments called “housing price hedgelets” based on single-family house prices in six different cities (Chicago, Los Angeles, Miami, New York, San Diego and San Francisco). Just as the CFE contracts, the HedgeStreet hedgelets are based on indices of NAR. CBOE and HedgeStreet announced on 22 February 2006 that they collaborated on retail distribution of their contracts via joint marketing initiatives and that they would share certain technologies and hosting facilities to achieve cost and distribution synergies. The agreement also involved an equity investment by CBOE in HedgeStreet.
Moreover, the London-based International Real Estate Exchange (INREEX) intends to offer contracts tied to average home prices published by the Office of Federal Housing Enterprise Oversight (OFHEO), the agency that regulates the mortgage organizations Fannie Mae and Freddie Mac. The exchange’s trading technology allows investors to trade the national or a state index online.
The low trading volume in the contracts based on the S&P/Case–Shiller index caused Radar Logic, an analytic and data company providing a range of daily indices and analytic tools, to launch a further index family for residential property. The Residential Property Indices (RPX) represent the median transaction prices per square foot paid in one of 25 Metropolitan Statistical Areas (MSAs) on any given day. In addition, there is a national composite index, representing over US$ 10 trillion in residential properties. The RPX market targets investors that are exposed to mortgage credit or to the housing market cycles in general.
