What Is a Property Derivative?

A property derivative is a financial product that fluctuates in value depending on the changes in the value of an underlying real estate asset, usually an index. Property derivatives provide investors with exposure to a specific real estate market without having to buy and sell tangible properties.

Key Takeaways

  • A property derivative is a financial product tied to an underlying real estate asset, such as an index.
  • The value of the derivative is influenced by the changes in the underlying asset, such as whether the index rises or falls.
  • Property derivatives allow investors to invest in real estate more indirectly, versus buying an actual property.

Understanding a Property Derivative

Property derivatives are a variety of financial derivatives. A financial derivative is a structure that takes its value from an underlying entity such as an asset, an index, or an interest rate. Examples of derivatives include futures, options, swaps, and property index notes. Derivatives are frequently used to hedge against price movements or to gain access to assets or markets that are otherwise hard to trade. 

Property derivatives typically replace a real property with the performance of a real estate return index such as the National Council of Real Estate Investment Fiduciaries Property Index (NPI). The NPI is the accepted index created to gauge the investment performance of the commercial real estate market and includes over 7,500 properties. As of the third quarter of 2020, the index is worth approximately $696 billion, across all U.S. regions and real estate land uses. The index is down 1.7% year-to-date amid the impact of the COVID-19 pandemic.

An index is used because individual real estate assets can be hard to price accurately and efficiently. A real estate index gathers information across the broad real estate market in an attempt to accurately approximate the value of underlying assets.

How Property Derivatives Work

Using property derivatives, investors can move in and out of all four quadrants of the real estate market, private equity, public equity, private debt, and public debt. Doing so allows them to manage risk and potentially increase returns to their existing real estate asset allocation.

An active derivatives market enables an investor to reduce upfront capital requirements and to shelter real estate portfolios on the downside while providing risk management strategies. 

Uses of Property Derivatives

One method of using property derivatives is to make a total return swap of the National Council of Real Estate Investment Fiduciaries index, broken down according to each property sector. The swap allows investors to take a position in an alternate property sector in which they may not already own properties.

Investors can then swap the returns from different sub-sectors, such as exchanging office-related real estate for retail real estate. Swaps allow investors to tactically change or rebalance their portfolios for a specific period, usually up to three years. Additional methods include “going long,” or replicating the exposure of buying properties, and “going short,” or replicating the exposure of selling properties.