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RISK MANAGEMENT

INTEREST IS STIRRING AMONG U.S. INVESTORS IN REAL ESTATE DERIVATIVES, AT LAST

By Dees Stribling

Derivatives have been a long time coming to the real estate investment market. And 2007, with its credit-squeeze woes, hardly sped the process. But according to those involved in the budding sector, the day is not far off when real estate investors will think in terms of “going long” or “short” as much as they currently follow occupancy or rental rates.

“The trading of real estate derivatives in the United States would have developed faster this year if the credit crunch hadn’t happened,” said Phil Barker, vice president of derivatives in the New York City office of GFI Group, a London-based derivatives brokerage. “There were a number of trades earlier this year, followed by a slowdown because of the debt market situation. Mainly, we’re seeing the uncertainty manifest itself as buyers staying on the sidelines, but I think it’s temporary.”

In the broader financial industry, derivatives have been standard for about two decades. The term applies broadly to a class of financial instruments, including futures, options and swaps, that are “derived” from other assets or groups of assets. They are parallel to and support the markets in almost every kind of tradable asset — stocks, bonds, commodities. Estimates vary, but perhaps up to $3 trillion worth of derivatives trade annually worldwide.

Though derivatives exist in a number of forms, at their heart is risk management. Each asset has its own risk profile. An investor who sells (goes “short,” in the parlance) transfers the risk in holding the asset to someone willing to buy it (one who goes “long”). Theoretically, there is no reason the assets involved cannot be real estate.

And yet commercial real estate is still the odd man out in terms of derivatives, at least in the U.S. (In Britain, especially, real estate derivatives have broader acceptance.) “It’s still a relatively new concept in the U.S. real estate industry, a new way to manage risk,” said Kiva Patten, a director at Merrill Lynch who specializes in real estate derivatives. “Like any new concept, it’s taking time for traditional players to get up to speed, but we’re beginning to see that now.”

Why the sluggishness for a U.S. real estate derivatives market? Some of it is simply a matter of unfamiliarity, says Jason Liddell, a vice president at Merrill Lynch. “Also, the word ‘derivative’ has been something of a hang-up for noncapital market players,” he said. In short, the real estate industry has long been used to thinking in terms of assets that are concrete, not derived from other assets.

“The reaction for years has been, ‘What is this exactly, and why should I do it?’ ” said Liddell. Moreover, in recent years real estate investors have perceived no need for the kind of sophisticated risk management that derivatives offer, because, on the whole, commercial real estate values have been going up.

Times are changing. The fundamentals of commercial real estate, including retail, are still considered strong, but the events of this summer spooked many participants regarding the future of real estate values. “Institutional owners of real estate now understand that the growth rate we’ve seen might not be as attainable in the coming years,” said Barker. “They’re beginning to consider putting hedges in place, using derivatives. They’re not ready to sell their physical assets, but the market is looking a little uncertain.”

Patten agrees. “It’s dawning on investors that derivatives offer a way to manage their risk synthetically, without giving up the properties that they want to hold,” Patten said. “They don’t want to relinquish properties that are performers, but they also recognize that any property can be affected by general market weaknesses. Derivatives can hedge out that market beta.”

As investors become more familiar with derivatives, they are also coming to understand the potential benefits, which differ for different kinds of real estate players. By strategically selecting derivatives based on a particular property type or geographic concentration, for instance, portfolio managers can enhance yields. Developers can hedge development risk, and individuals can use them as a relatively low-cost synthetic real estate investment. Major owners such as pension funds can use them to achieve portfolio diversification without the expense of direct investment in additional kinds of real estate, while lenders can employ derivatives to protect themselves from the downside risk of their loan portfolios.

Futures represent one of the main avenues for growth in U.S. real estate derivatives. The Chicago Board of Trade launched an example of a real-estate-based futures product early this year: a futures contract based on the Dow Jones U.S. real estate (DJUSRE) index. Currently, the index comprises 91 stocks, of which 85 are REITs; futures contracts based on the index trade electronically six days a week, at a value equal to $100 times the value of the DJUSRE.

Investors can protect themselves from price risk in the REIT market by shorting these kinds of contracts. Also, such futures will probably evolve into a tool for price discovery of the underlying real estate assets. Though there is no absolute correlation, REIT share prices often fluctuate because of such factors as vacancy and rental rates, which are then reflected in the index.

REITs are not the only basis for real estate futures contracts. About a year ago the Chicago Mercantile Exchange and Global Real Analytics jointly launched a futures product based on the GRA commercial real estate (CREX) indexes. There are 10 of these indexes, one for each of five U.S. regions, one each for the apartment, industrial, office and retail property sectors, and one composite index.

Another major class of derivatives on the horizon for real estate involves total return swaps. In its simplest form, the underlying basis of a swap can be any asset that generates a return. In a total return asset, the seller does not actually sell the asset, but rather the returns of that asset over a specified length of time. In the case of a real estate asset, that would be the cash flow as well as the property’s appreciation.

In return, the buyer of the swap pays the other party a cash flow based on LIBOR (London interbank offered rate) plus a spread over the specified time period. Thus, the risk of owning the asset is transferred from the seller, which receives a fixed return for a fixed period, to the buyer, which is more willing or able to bet that the asset will return more than the LIBOR-based payout. At no point does the asset change hands, making the deals susceptible to high levels of leverage, and this is why hedge funds have taken to them in a big way.

In the U.S. private equity real estate market, swaps are increasingly based on National Council of Real Estate Investment Fiduciaries (NCREIF) return indexes. One form of the swap allows investors to either buy (known as going long) or sell (going short) the NCREIF return, while the other product allows investors to swap total returns on two different NCREIF sectors, such as swapping retail for industrial, or apartments for office. All are over-the-counter deals, and currently there are seven market makers in place — those companies licensed by NCREIF to make markets against its family of indexes.

With the cost of borrowing up, and thus, potential returns from real estate down, GFI Group’s Barker says buyers are less keen right now to buy into derivatives than they were at the beginning of this year. “The NCREIF returns were in the mid-to-high teens in 2006,” he said. “In the next two years, the returns will be more in the order of 4 and 5 percent. Buyers need to acknowledge that will be the rate of return, and I don’t think they’re quite ready. But in the long run, swaps will prove too useful to ignore. They will become a standard tool in real estate, just as they’ve become for other assets.”