Real Estate Derivatives: It's Our "dot-com" Time

Journal of Real Estate Portfolio Management, Jan-Mar 2008 by Valente, James

In case you haven't noticed, a derivatives market has been developing for private equity real estate investors. This is important, because it will enable investors to more efficiently manage nonsystematic risk, and for the first time manage systematic risk. Unfortunately, my participation in the development of this market over the past two years leaves me feeling as if we are in a ".com" environment similar to what the technology sector went through in the late 1990s; this person has a business plan, another has the perfect index, another has a new pricing model, and on and on. While all of this has been occurring, institutional investors are sitting on the sidelines waiting for liquidity to develop and trying to understand the basics of derivatives and if or how they can use them.

In what follows, I present some thoughts, questions, and issues for both academics and practitioners that, if understood better, can help this market develop to its full and necessary potential; some of the proposed areas of research focus on original research, others are more practical in nature but no less important. By no means do I suggest that my ideas are all inclusive, but I do believe they are more pertinent than some of the research on this topic that I have recently read.

The primary reason a better understanding of derivatives and their applications for real estate investors is important can be illustrated by a recent example. Between July 2007 and December 2007 a group of investors, including opportunity funds, hedge funds, and a few sophisticated debt investors used credit default swaps against single name CMBS and the CMBX indices to completely reprice the cost of real estate debt and equity. Indeed, the bets these firms made were the correct ones, and their effects are currently being felt by real estate investors who were not active in derivatives markets or even thinking about the impact of derivatives pricing on their portfolios. While this was occurring in the United States, large institutional investors in the United Kingdom foresaw a combination of extremely low cap rates in a rising interest rate environment and moderating demand for office space combined with growing levels of construction, which were still a couple years away from delivery. Their conclusion was that prices were too high so they shorted the IPD Index to the tune of a couple billion pounds. The end result of these bets was to help push U.K. IPD returns negative in the second half of 2007 even though occupancy was strong and rental rates were still rising. Going forward, we will all experience much more volatility in returns, as fast money from global hedge funds and opportunity investors move in and out of positions, increasing the speed and magnitude of changes in the cost of real estate debt and equity capital.

In order to help investors better understand derivatives and their applications so that they are not whipsawed by evolving capital markets forces and able them to build more efficient portfolios, I think there are two basic areas related to real estate and derivatives that academics and practitioners should focus further research on over the short term. First, there needs to be an emphasis on uses (products/strategies) of different types of derivative products, including property and credit derivatives. Second, there needs to be a more rigorous analysis of available indices and what constitutes a good benchmark; the index debate that has been going on for the past two years has been unproductive and less than factual.

Uses

To date, much of the derivatives debate in the real estate community has focused on property derivatives, and excluded other products such as credit default swaps; this has been unfortunate. There have been a number of white papers and articles written regarding the use of property derivatives for developing tactical allocations, getting the money out and more efficient investment (lower transaction costs); I will not expand on this work here as it is fairly straight forward. Alternatively, property derivatives and credit default swaps should be able to be used to develop more efficient risk management strategies than has previously been achievable through "long-only" investment plans. I think this is the most important area of research for real estate investors. Research into the development of new derivatives products and hedging strategies based on both of these products is much needed. For example, it has been shown in the equity world that a long/short strategy can provide more effective diversification than a long only strategy, especially if the returns of the stocks are more correlated. Does this apply to market targeting strategies practiced by real estate investors? Can real estate investors develop portable alpha strategies, or are the challenges of a private equity world too great? What about structured notes? Rather than thinking of these instruments as a way to get the money out, can they provide investors with a more efficient source of debt than traditional mortgage markets?