Real Estate Derivatives and Property Indicies

I recently attended a presentation on hedging real property transactions in the derivatives market given by Stephen Gould of Vyapar Capital Partners. Going into the presentation I knew next nothing about property indicies and related derivatives products so I’m going to walk through the basics of his presentation assuming that, like me, you have little knowledge on the topic. I’ve embed his entire presentation below so you can get into the gritty details that I’ve purposefully excluded.

Property Indicies
Since real estate assets fall victim to market inefficiencies and are hard to accurately price, derivative contracts are typically written based on a real estate property index. The general principal of index calculations is the same in real estate as it is elsewhere.

Index return % = Value at end of the period / Value at the beginning of the period-1

However, there are problems with real estate since it’s a unique asset class:

• Most real estate does not trade within index measurement periods
• Value of an individual building depends not just on land and building value, but rental agreements in force etc.

So, Mr. Gould  explains that “the only accurate index is where all the assets underlying the index are traded at the beginning and end of the index measurement period and no change to the assets takes place in the mean time”

There are 3 basic index types:

• Appraisal-based – The most common form of property index, where property values are determined by appraisal reported to the index provider. Keep in mind that there is no guarantee that appraisals reflect real values – there is evidence that appraisers tend to be conservative, particularly in declining markets.
• Transaction-based – Values are determined by actual transactions on per square foot basis to allow for comparability. This index requires transactions to actually take place.
• Repeat sales – This is by definition transaction-based. It looks at properties actually bought and sold which avoids the problems inherent in appraisals.

Index Providers:

• NCREIF – The National Property Index (NPI) is an appraisal-based index that is produced quarterly by valuing the properties in the NCREIF database. This is the benchmark for the US pension fund industry.
• IPD – In 2009 IPD launched an index series for US commercial property. As with their other indices,
  their US indices are appraisal-based.
• ReXX – Total Returns are produced quarterly and calculated for the US Office market based on lease
  transaction prices, asking rents, Effective Fed Funds and CPI.
• Moody’s/Real CPPI – This is a joint venture between Moody’s and Real Capital Analytics. Transaction data is
  sourced from NCREIF and elsewhere, using deals over $2,500,000 in value. Moody’s/Real
  uses the repeat sales method.

Mr. Gould summed up the indicies as followes – “NPI is what we think happened, Moody’s/Real is what actually happened, and ReXX is what should have happened”. Suffice it to note that NPI is down 24% from its peak while CPPI is down 43% from its peak.

So how can asset managers, developers, hedge funds, portfolio managers, commercials lenders and bondholders use property derivatives to hedge a new project? For the sake of this post I’m just going to cover the very basics, see the presentation below for a more in-depth analysis.

• Forward Contracts – Simply put it’s an agreement between two parties to buy or sell an asset at a certain price in the future. You agree upon a notional amount, a settlement date, an underlying index, and the forward price is agreed on inception.

Example

• $25,000,000 forward from 6/1/10 to 12/31/11
• Priced off S&P/Case-Shiller National Index
• Settlement price of 175 agreed at inception

On 2/24/12, the index release (for end-Dec 11) is 185.
Payment: (185/175 – 1) x $25,000,000 = $1,428,571 to buyer of forward.
If price had fallen below the settlement price, the buyer would have had to pay to the seller on
expiration.

• Options – A RE Option is a contract based on a time horizon and an expected property value.

Example

• 220 6-month call on S&P/Shiller NI on $10,000,000 notional, premium 0.50% = $50,000
• If index is below 220 in 6 months, option is worthless
• If index is above 220 in 6 months, buyer receives: $10,000,000 x (Index/220 – 1) in cash.

• Total Return Swaps (TRS)

Example
Property owner A and investor B agree to enter into a

• $25,000,000 swap of
• NPI versus 4%
• Deal date 1/15/10
• Start date: 12/31/09
• End date: 12/31/11

Every year (or every quarter), A pays B the cash value of total return of the index for the year
on the notional amount. Every year, B pays A the cash value of the funding leg rate on the notional
amount.

With this post I basically wanted to lay the groundwork on property indicies and the use of derivatives. There are a number of reasons and scenarios for end users to buy property derivatives. See the presentation below for the different types of hedges and a case study on a property developers use of derivatives.

Property Derivatives Presentation

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• Gravity Returns: The ongoing re-pricing and de-levergaing of commercial real estate
• Builders Corner – The Benefits of Leverage
• Tom Barrack: The Real Real Estate Business

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