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

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

From a forecasting perspective, we need to develop a better understanding of the relationship between forward curves and actual pricing in the cash market. This will absolutely help our ability to forecast future performance, which today is horrible. By this I not only mean forward curves for property derivatives, but also credit default swaps, which should foretell future performance if there is any link between the credit of tenants in a building and the value of the cash flows those tenants generate. Better forecasting abilities will not only create more efficient derivative pricing, but more importantly, more efficient physical asset pricing.

Indices (Property)

Over the past year and a half, three new indices have been introduced that could potentially provide a basis for derivatives products. First, Moody's and REAL (a spin out of Real Capital Analytics) have introduced the Moody's/REAL CPPI, a transaction-based index that utilizes a repeat sales methodology (www.realindices.com). Additionally, Standard & Poor's has partnered with GRA/Charles Schwab (www.indices. standardandpoors.com) to create a transaction-based index that incorporates a weighted average methodology. Finally, REXX (www.rexxindex.com) in partnership with Cushman & Wakefield and Newmark Knight Frank has developed an index that is generated by an econometric model that uses changes in specific macro variables and rents as its inputs.

None of these indices, including NCREIF, are perfect. Indeed, they may all suffer from different but equally significant limitations for different types of real estate investors. It is easy to point out the short comings of NCREIF, as academics and practitioners have been picking it apart for nearly 30 years. Alternatively, these other indices have been around for about five seconds. And, while the back testing of these indices to date may provide statistics that support their creator's contention that they are the newest and best "mouse trap," none of them has been sufficiently vetted to be considered the "best" or most accurate; not to mention that there is a big difference between statistical significance and practical usefulness. The fact that these indices haven't experienced a complete cycle, especially important for the transaction indices, means we don't know how they are going to hold up over time. Further, new criteria necessary for a "good" derivatives index has been proposed as a measuring stick, but the criteria introduced are inconsistent with AIMR guidelines for a good benchmark.

So, what do we need to know going forward? First, it is important to know how NCREIF and the proposed new indices stack up to AIMR guidelines for a "good" benchmark, which should be the test of a good index; individual investors tracking error doesn't mean the index is bad. second, each of the new proposed indices needs to be vigorously vetted over a complete cycle. Most investors generally prefer a transaction-based index over an appraisalbased one if the transaction-based index reflects the true change in market prices, but do the currently proposed indices do that? Their lives span a fairly unique period of high liquidity that saw the cost of capital for smaller local investors equal that of large institutional investors. Will this be the case going forward? If it is not, can a transaction-based index that is dominated by small transactions (