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.
Get quick access to the property market with a loan
The British commercial property market is estimated to be about GB£ 600 billion. Pension funds, property companies and other professional investors own about half of this amount according to the Investment Property Forum (IPF) the parent company of PDIG. On the buy-side, a diverse range of institutions, investment banks and individuals exists. Either they are unable to get quick access to the property market or want to rebalance an existing property portfolio. On the sell-side, there are large property funds that worry about a market downturn and want to reallocate a property investment to bonds or stocks. In other words, sales involve larger volume trades and buys smaller ones.
In 2006, the buy-side was easier to see and to find than the sell-side. Investors were keen to take exposure to the underlying property index, while few investors with physical property exposure were willing to sell. In 2007, the situation has changed. Many investors such as large insurance companies are now concerned about their property investment and willing to hedge, while it is no longer clear who wants to take on the exposure.
For professional real estate investors, derivatives on the IPD All Property Index are a relatively crude tool since these investors often want to express a view on more finely differentiated subsectors, such as retail warehouses or offices in central London. Sector swaps started to bring the market closer to the needs of fund managers. Disaggregation could further play an important role in the property swap market, since the All Property side could feed off growth in the sector trades.
It is possible to make a credit funded investment
Alternatively to an unfunded swap or CFD, it is also possible to make a funded investment. Rather than paying LIBOR plus a spread quarterly and receiving property returns, the investor pays the notional amount of cash upfront and receives property returns net of the spread. For example, on a two-year swap an investor could choose, rather than paying LIBOR plus 1% on the swap, to pay 100% of the notional amount and receive the property return minus 1% each year and 100% redemption after two years.
The basis for property derivatives documentation is the International Swaps and Derivatives Association (ISDA) documentation. Just as for other derivatives, ISDA has prepared standardized documents for property swaps, in order to facilitate trading. The Property Index Derivatives Definitions were published in May 2007. Standardization aims to reduce transaction costs, legal risk and transaction time, to increase transparency and confidence in the market, and to improve efficiency and liquidity. In addition to the definitions, ISDA provides confirmation templates for forwards and swaps in the US (Form X) and in Europe (Form Y), as well as an annex that describes the indices on which the trades are based. By September 2007, the Association has included the Standard&Poor’s/Case–Shiller Index, the Office of Federal Housing Enterprise Oversight (OFHEO) Index, the National Council of Real Estate Investment Fiduciaries (NCREIF) Index, the worldwide Investment Property Databank (IPD) Indices, the UK Halifax House Price Index, the FTSE UK Commercial Property Index and Radar Logic’s Residential Property Index (RPX). The definitions booklet covers issues such as disruption events on these indices. More indices, as well as confirmation templates for options and basket trades, are likely to follow.
The capital credit value components
In early 2007, further banks were granted licences to trade the NCREIF property index and are planning to launch a US platform to trade property derivatives (Four more banks, 2007). By December 2007, seven banks were licensed to trade derivatives on the NCREIF commercial property index. Besides Credit Suisse, Bank of America, Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley are involved. The traded volume reached US$ 300 million by late 2007. More banks are expected to sign up for a licence contract within a few months (Banks move, 2007; Property derivatives, 2007). Given the potential, hedge funds and insurance companies are also starting to show interest in developing the US market for property derivatives.
Credit Suisse initially offered three basic trades to investors: Price Return Swaps on the capital value return component of the NPI, Property Type Swaps on the total return by property type subindices (for all reported property types except hotels, as hotels comprise only less than 3% of the overall index) and Total Rate of Return Swaps for the NPI total return:
In a Price Return Swap, the capital value return component, published quarterly by NCREIF, is exchanged against a fixed spread. The fixed spread is used to balance demand on both the long and short sides of the trade (see Chapter 8 on the property spread).
A Property Type Swap on the total return by property type subindices is a total rate of return swap transaction in which an investor takes a long position in one property type and a short position in a different property type, based on the respective property type subindices. Depending on the property type swap that is entered into, the investor will either pay or receive a fixed spread to enter into this swap. The fixed spread will be determined by supply and demand in the market, and therefore could be positive, negative or zero.
In a Total Rate of Return Swap for the NPI total return the quarterly total return published by NCREIF is exchanged against a three-month LIBOR plus or minus a spread. The spread is used to balance demand on both the long and short sides of the trade.
All trades are notional based. This means that they are unfunded and the only cash needed upfront to enter the trades are margin requirements necessary to manage counterparty risk evaluated on a counterparty-by-counterparty basis. The trades settle quarterly and have a maturity of two to three years. In April 2007, the property company CBRE claimed that the first trade on a US subindex had been closed.
