Historically, real estate has had a low correlation to stock and bond investments, but buying and selling physical property is not nearly as simple.

Enter real estate derivatives, or property derivatives. These instruments allow investors to gain exposure to the real estate asset class, without having to buy or sell properties by replacing the real property with the performance of a real estate return index. These derivatives are based on swaps, where one party swaps one exposure for another. In this way, investors can get exposures to either real estate equity or debt, without ever buying a real estate asset or lending capital with real estate as the collateral. Read on to find out how they work.

Introduction to Derivatives
The National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index (NPI) is the accepted index created to provide an instrument to gauge the investment performance of the commercial real estate market. Originally developed in 1982, the unleveraged index is made up of more than 7,200 properties, worth a total of about $315 billion (as of Q3 2012) from all the U.S. regions and real estate land uses.

Although this index has been in existence for more than 20 years, it is only recently that data has become transparent enough to allow it to accurately and appropriately track the performance of equity real estate. With real estate data becoming more transparent and transaction information becoming easier and less costly to obtain, real estate indexes have become more relevant, leading to the creation of an increasingly efficient derivatives market.

Real estate derivatives are a way for investors to gain exposure to the asset class without the need to buy or sell properties by replacing the exposure of the real property to the performance of a real estate return index. This allows an investor to reduce his or her upfront capital requirement and to shelter real estate portfolios on the downside, while providing for alternative risk management strategies.

Commercial real estate investments are categorized into the following investment types:

The introduction of swaps based on the NPI was developed for the private equity sector. They were the precursor for the rest of the real estate derivatives developed to date. The derivatives offered to date on the NCREIF index are "swaps" that come in various forms, allowing investors to swap exposure on either the appreciation or total return of the index itself, or by swapping exposures from one land use to another.

One method is to "go long" (replicating the exposure of buying properties) or "go short" (replicating the exposure of selling properties). Another method is to swap the total return on the NCREIF index broken down by property sector, allowing investors to take a position in an alternate property sector in which they may not own properties, thus allowing investors to swap the returns from office related real estate for retail real estate.

The return swap allows two investors on either side of the swap to execute real estate strategies that cannot be accomplished in the private real estate market. To do so, one would have to buy or sell assets with different exposures with little chance of securing the same assets at the same investment basis to reverse the strategy. Swaps allow investors to tactically change or rebalance their portfolios for a specific period of time without having to transfer title to the assets currently on the balance sheet. Contracts for up to three years are usually managed by an investment bank, which acts as the clearing house for the funds.

In the case of an investor going long the total return of the NCREIF index, he or she would accept the total return on the NPI (paid quarterly) on a predetermined notional amount and agree to pay the LIBOR rate, plus a spread on the same notional amount. The other party to the swap would receive the same cash flows in reverse, pay the quarterly index return and receive LIBOR plus the spread.

Assuming that there are investors for both sides of the trade, two investors wishing to trade one property exposure for another could trade the return of the NPI for that particular property type for another. For example, a portfolio manager who feels that his or her fund is over-allocated to office properties and under-allocated to industrial could swap a portion of the office exposure for industrial without actually buying or selling properties.

Public Equity
Instead of the NPI, derivatives for exposure to the public equity sector of the commercial real estate market use the total return of the National Association of Real Estate Investment Trusts (NAREIT) in order to calculate the cash flows accepted (for the long investor) or paid (by the short investor).

This index provides the performance return for the market of public securities collateralized by commercial real estate. The swap receiver pays LIBOR plus a spread to go into a one-year index swap with a $50 million dollar notional amount, and he or she would receive quarterly payments from the NAREIT index on $50 million. Once again, the investor can get a fully diversified public real estate exposure without buying a single asset.

Real Estate Debt
Due to the breadth and depth of the tranches of different risk profiles from the underlying pool of commercial real estate mortgages found on the commercial mortgage-backed securities (CMBS) market, real estate derivatives are also available on real estate debt positions. The swaps for public real estate debt are based on indexes of the CMBS market. These indexes, unlike those for equity real estate, have been around since the late 1990s.

Thanks to the breadth and depth of the data from a large number of transactions (relative to equity real estate), the CMBS indexes are a much better performance indicator for their respective markets than those for their equity counterparts. The most notable difference between the equity swaps and the debt swaps is that the receivers of the LIBOR-based payments receive LIBOR minus a spread, as opposed to the equity swaps, which are usually based on LIBOR plus a spread. This is because underlying securities are usually financed by short-term revolving repo term debt, which is usually at LIBOR minus a spread. This is the exposure that is passed on to swap counterparties.

Private real estate debt derivatives, such as credit default swaps (CDSs), are usually used to hedge credit risk. Derivatives, such as loan swaps, provide the swap party with both the interest rate and credit risk, while the asset (a commercial real estate loan) remains on the counterparty's balance sheet. Thus, a mortgage lender may hedge portions of its debt portfolio for various investment terms without having to sell the loan itself. In this way, the investor can move out of certain sectors of the real estate market when they feel the return does not commensurate with the risk, and then later regain the exposure when the market for that particular sector improves.

The Bottom Line
Because commercial real estate assets are capital intensive and relatively illiquid, real estate investors have found it hard to hedge their exposure or execute alpha strategies. Real estate characterized by high transaction costs and a market less efficient than stocks and bonds have added to the difficulty in rebalancing portfolios in response to market changes.

Real estate derivatives have changed the commercial real estate market by allowing investors to tactically change their exposures to specific risks and opportunities without the need to buy and sell assets. These derivatives allow for exposure to either a different sector of the real estate equity market or by trading a real estate exposure for a variable interest rate plus or minus a premium.

The ability to swap exposures allows the real estate investor to become more tactical when investing. They can now move in and out of all four quadrants of the real estate market, which allows for greater risk management and the potential for adding increased return to their existing real estate asset allocation on either a short-term or longer-term investment horizon.

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