The author discusses the securitization of real estate and how derivatives evolved as a means to minimizing the various risks emerging from different asset classes and regions around the United States. It provides examples of different derivative products and how they are structured to hedge or minimize the investor's risk as it relates to their underlying asset.

"Real estate already is volatile and risky — like the stock market, and the risk is increasing. The impression that real estate market only goes up is wrong. We need hedging for both sides."

As unfortunate as it may seem, real estate has its peaks and troughs like any other asset and/or security. For many years, derivatives have been trading heavily on different types of securities in order to minimize portfolio risk and exposure during turbulent times. In order to derivatize an asset, however, it must be a continuously traded asset, which ultimately leads to the liquidity of the asset. However, real estate is not a liquid asset and is not continuously traded. Furthermore, real estate is a heterogeneous product and has a high barrier of entry. Shiller's quotation addresses the reality of life — what goes up must come down, and vice versa.

Until most recently, the development of real estate derivatives has been a slow process; investors had not seen a need to diversify real estate risk. However, over the course of the last eight to 10 years, real estate values have been consistently rising. Yet, as property owners start to take into account the volatility of the market, they are beginning to understand the risk involved and the subsequent need to manage and diversify away from it. In a phone interview, Ricardo Pereira from Bank of America's Structured Finance group explained:

"Property derivatives allow risk diversification as any other investment product. The degree of diversification will be a function of the portfolio's composition. It is known that physical property's returns have low correlation with equity market's returns. In this sense, it allows diversification and at the same time it will decrease portfolio's systematic risk, if the benchmark is an equity market proxy. If, for example, the proxy is a Real Estate Equity index, this effect can be smaller. In the end, the observed impact on the portfolio's beta will depend on the benchmark and on the underlying of the property derivative."

This article discusses the securitization of real estate and how derivatives evolved as a means to minimizing the various risks emerging from different asset classes and regions around the United States. It goes through examples of different derivative products and how they are structured to hedge or minimize the investor's risk as it relates to their underlying asset.

Derivatives

A "derivative" in its most basic form is defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables. Very often the variables underlying derivatives are the prices of traded assets. Derivatives can be dependent on any variable from the price of stocks to the price of coffee beans. There are several types of derivatives; they include: options, futures, forwards, and swaps. Simply put, an "option" is the right to buy or sell an asset and a "future" is a contract that obligates the holder to buy or sell an asset at a predetermined delivery price during a specified period. Like a future, a "forward" is a contract that obligates the holder to buy or sell an asset for a predetermined delivery price at a predetermined future time. A "swap" is an agreement to exchange cash flows in the future according to a prearranged formula. Swaps are a popular means of managing risk exposure to swings in the market.

Derivatizing Real Estate Assets

In order to derivatize an asset, it needs to be a continuously traded asset and one that is liquid to the markets. Additionally, information is not as readily accessible for real estate the way it is for publicly traded companies. These market variables are hindering the breakout of real estate derivatives; it is therefore imperative that these issues be addressed and the real estate asset securitized. The first step made towards establishing a more securitized real estate sector was the Real Estate Investment Trust, otherwise known as a REIT. The structure stipulated that a company would raise money from the public markets and trade as any other equity would, but it also implemented many rules and restrictions around distribution and tax laws.

As time passed, real estate indices began to appear, which revolutionized how investors could invest. The first in a series of changes was the property index — an example of which was the Case Shiller Home Price Index. This innovation promoted the tracking of home prices throughout the United States. The establishment of these types of property indices has enabled investors to invest in an index that tracks home prices as opposed to buying the physical asset itself. Hence, the high barrier of entry which was once prevalent has now been eliminated.

Robert Shiller and Karl Case developed the Home Price Index approximately 20 years ago to give homeowners and investors the insurance that they needed. However, it also allowed for more transparency in the market. Transparency was one of the main reasons Fox Property Futures failed at launching property futures in the early 1990s — false market prices were apparently being maintained, which flawed the price discovery mechanism paramount to any futures market. However, the United Kingdom expanded on this idea. In the U.K., the main property index now used is called the Investment Property Databank ("IPD"). Approximately €700 million of real estate derivatives were traded in 2005, and approximately double that in 2006. Today, over €5 billion worth of real estate derivatives are being traded.

Hedging a Homeowner's Risk

Case, Shiller, and Wise were concerned that homeowners lacked insurance against declines in home values. Given the unique nature of the real estate market, it is important to create some sort of benchmark in order to establish the proper derivative system and market to protect against property devaluations. The Home Price Index is apropos for this type of hedging. The method by which a homeowner could diversify risk would be to buy a put option against the property index — the option to sell an asset at a certain price. If the housing market collapsed, the homeowner could diversify the risk away from the physical asset to the derivative, exercising the put option to minimize overall loss. This would significantly reduce exposure to idiosyncratic risk; it would mirror the asset in reverse, making the homeowner less vulnerable to a downturn.

Derivatizing in Other Industries

The hospitality industry has mimicked this same strategy. There is now an index that tracks Average Daily Rates ("ADRs") of hotels in the United States — a key indicator of profitability — called the HQuant Lodging Index ("HLI"). The index gathers information on over three million hotel rooms, or 70 percent of the nation's total, allowing investors to participate in the future performance of the hotel industry without investing in the underlying asset. Dr. Daniel Quan of Cornell University's School of Hotel Administration noted that investors will be able to participate in the daily profitability of a hotel without the much larger investment of purchasing the real estate. Lenders in this sector can benefit as they can hedge their position against default risk from declining ADRs, since declining ADRs can push the Debt Service Coverage Ratio ("DSCR") below one — meaning the hotel owner cannot cover debt from income the hotel produces.

Another known index is the NCREIF (National Council of Real Estate Investment Fiduciaries) Property Index, or NPI, which benchmarks U.S. commercial real estate. Commercial real estate is one of the last securitized asset classes in the real estate sector. This is an appraisal-based index, which can cause short-term discrepancy because it is not market based and may take time to correct itself; price discovery is not as apparent, so option and futures trading are a safer bet longer term. Up until April 2007, Credit Suisse First Boston was the only bank with exclusive rights to write derivative contracts against the NCREIF — now the contracts are offered through many other banks. The index tracks over 4,000 institutional level properties valued at over $250 million, segmented by asset class and region, which is valuable for investors who need to hedge their position by asset type and region. For example, an investor who owns retail properties on the West Coast, or a retail lender, could purchase a put option on the West Coast retail index — should the retail sector take a nosedive, the put option can be exercised to hedge the position.

Swaps

Another way to use the NCREIF as a base index for derivatives is the swap — a very popular and actively traded product in the financial markets. As previously stated, a swap is an agreement to exchange cash flows in the future according to a prearranged formula. Many large and small pension funds use this form of derivative to either hedge their bets or maintain their portfolio's weight structure.

For example, imagine two funds, ABC and XYZ. ABC is a smaller fund that does not want to invest directly in real estate, since it is illiquid and too expensive an asset for the fund's requirements. XYZ, on the other hand, is a larger fund that currently owns real estate and, due to current market conditions, needs to reduce its real estate exposure. In this scenario, the two funds essentially swap cash flows: Fund ABC takes a long position, swapping a fixed return for the NPI appreciation return, while Fund XYZ takes a short position, swapping the NPI appreciation return for the fixed return. Each quarter, XYZ pays ABC the NPI appreciation return, while ABC pays XYZ the spread, or "fixed leg" — typically LIBOR plus a certain spread. This continues every quarter for the duration of the contract, which typically lasts two to three years.

To quantify this: on a notional amount of $1,000,000 with a one percent fixed leg, if NPI appreciation in year one is two percent, XYZ owes ABC $20,000 while ABC owes XYZ $10,000 — a net cash flow of $10,000 from XYZ to ABC. If NPI appreciation were negative instead, ABC would owe that percentage decrease multiplied by the notional amount. No money is initially exchanged. This flexibility is particularly important to large funds, since it lets them correct overexposure — for example, from the "denominator effect," where a decline in one asset class (like stocks) mechanically overweights a fund's other holdings — without having to sell the underlying real estate itself.

Mortgage Backed Securities

Reverting back to property indices, there is a relatively new phenomenon of structured financial products such as Commercial and Residential Mortgage Backed Securities ("CMBS" and "RMBS"). These Mortgage Backed Securities ("MBS") are pools of loans aggregated and tranched by risk factor, then sold in a manner similar to bonds. According to The Bond Market Association, gross U.S. issuance of agency MBS was:

  • 2005: USD 967 billion
  • 2004: USD 1,019 billion
  • 2003: USD 2,131 billion
  • 2002: USD 1,444 billion
  • 2001: USD 1,093 billion

Mortgage Backed Securities play a large role in the financial world, seen as a great diversifying tactic for large funds and investors. Buyers of these securities offset the risk of these loan pools by purchasing derivatives — should the mortgages begin to default and the mortgage market collapse, the value of these derivatives increases, and the counterparty on the other side of the derivative must make a large cash payout to cover the decline. That counterparty then has to find a way to fund the payment, often by selling another asset — a spiral effect evident in the subprime mortgage sector, where large volumes of loans defaulted and large institutions and funds struggled as a result.

The mortgage backed security market led the way for derivatives. Although a slow process, it has become more and more prominent. As real estate investment concentrates less on direct ownership, speculative price movements on the real estate market are reduced, smoothing out the business cycle — volatility in the underlying asset slowly diminishes as speculative buyouts or sellouts become less likely.

Conclusion

The market for real estate derivatives is a relatively new one. While still under research, it is becoming more prominent as investors and lenders recognize increasing risks in the markets — interest rate risk, liquidity risk, and, most importantly, credit risk, as seen in the mortgage backed security industry. Within the past decade, real estate derivatives have become more popular: the hotel sector is creating sub-indices to track ADR in specific markets, similar to NCREIF, as seen with HQuant; the property market continues to grow more specialized criteria, as seen with the Case Shiller Home Price Index catching up to the IPD in the UK; and the office, retail, industrial, and apartment sectors are seeing more liquidity through NCREIF.

Although these indices have their faults due to timing and lag issues, they have come a long way. The derivative market is only as good as its benchmarked index, and more research is needed to refine the quantitative pricing for options, futures, and forwards as they relate to real estate, which behaves quite differently than the equity markets. Index-based derivatives, by definition, only address systematic risk — but real estate carries significant idiosyncratic risk as well, and the underlying pricing model needs to be adjusted to resolve this. Although real estate is the last major asset class to be derivatized, it will continue to grow into a respectable benchmark alongside the IPD and other foreign markets.