New ways to hedge real estate

Investments based on real estate price indexes will be traded in the United States beginning in the first quarter of next year, opening up the multitrillion-dollar real estate markets to institutional investors and large corporations like never before.

The new derivatives will not only give investors the ability to invest in real estate without having to buy bricks and mortar, they will also give finance executives new opportunities to hedge their corporate real estate assets.

Standard & Poor’s and Global Real Analytics are gearing up to launch several commercial real estate indexes, with the Chicago Mercantile Exchange agreeing to trade futures–and options on futures–based on those indexes. Additionally, Goldman Sachs intends to offer a series of home-price derivatives tied to the S&P/Case-Shiller home price indexes within the next few months.

With public real estate investments, as measured by the NAREIT index, yielding returns of 30.41% and 8.29% in 2004 and 2005, respectively, and private real estate investments, as measured by the NCREIF index, earning 14.49% and 20.06% during the same two years, the appeal of real estate continues to grow.

Hedge funds and private equity shops have joined large public pension funds and corporations as major investors in both public and private real estate, which are expected to enjoy double-digit returns this year.

“Being able to use derivatives or some reasonable facsimile to hedge one’s direct cash exposure and real estate is of some interest to folks,” said John Kriz, managing director of real estate finance at Moody’s Investors Service.

For example, he said long-term investors with billion-dollar real estate portfolios, such as MetLife, the TIAA-CREF pension fund and Prudential Financial, could benefit from derivatives.

“Selling [real estate] takes a while, and maybe you’d like to hasten that, so you might use derivatives to move from one cash market to another,” he explained. “It happens in securities all the time.”

Mr. Kriz also said that if corporate executives thought the real estate market was going to be down, derivatives could provide downside protection against their core real estate holdings.

Institutional investors and corporations can benefit in other ways as well. David Blitzer, managing director and chairman of Standard & Poor’s index committee, pointed out that futures could allow potential investors to buy into a market and benefit from its rise before purchasing actual real estate. “In effect, you can buy in early and then, when you actually buy what you’re planning to buy, you can sell the futures and shift from being in the futures market to being in the actual market,” he explained.

Mr. Blitzer noted that because derivatives can be bought or sold virtually on the spot, they are much faster to buy or sell and more liquid than actual real estate. And since real estate transactions include legal fees, taxes and other costs, derivatives lower the costs of investing in real estate as well. Steve Mallen, senior managing director of global client services for Grubb & Ellis, said one of the greatest challenges to real estate derivatives is the quality of the indexes and benchmarks they are derived from.

He said he has seen real estate derivatives grow consistently over the last three years in the United Kingdom, with transactions reaching an estimated oe3.5 billion ($6.7 billion) this year from oe1.5 billion in 2005. Next year, real estate derivatives trading in the U.K. is expected to top oe5 billion, he said. “If the industry can come together to create a viable benchmark that is seen as independent, reliable and mass-market accepted, then derivatives have a potentially great and large future,” he said.