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Derivatives Debut in Commercial Real Estate

With capitalization rates flattening in most markets, commercial real estate owners face the real possibility that their property values may drop for the first time in years. Thanks to new indices from some of the country's top traffickers in market data, however, investors have the option of hedging their investments through derivatives trading.

“In a market that's going up 10% a year, nobody's thinking about hedging their portfolio, but we really are at a tipping point where the hedging of assets starts to make sense,” says Neal Elkin, president of Real Estate Analytics LLC, which publishes the Moody's/Real Commercial Property Price Indices.

Derivatives are contracts that enable investors to quickly stake a position in a market without acquiring a hard asset. The contract uses a benchmark, such as an index of real estate market performance, as the basis for payments between parties.

Portfolio managers can use derivatives to swiftly achieve diversification goals without going through the process of finding and acquiring properties. As a hedge against lost value on a hard asset, an investor can sell short against the index so that marketwide losses will be offset by the increased value of the derivative contract. Of course, derivatives gain and lose value with the ups and downs of the index, so investors must exercise caution.

Both Standard & Poor's and Moody's Investors Service have introduced commercial property indices this year in partnership with outside sources. In September, S&P and GRA/Charles Schwab Investment Management unveiled the S&P/GRA Commercial Real Estate Indices, which reflect sales data collected by Charles Schwab Investment Management coupled with 13 years of historic data from McGraw-Hill Construction.

Then in October, Moody's teamed up with Real Estate Analytics to publish the Moody's/Real Commercial Property Price Indices, a set of 29 indices based on data from New York-based research firm Real Capital Analytics. Both the Moody's and S&P indices use sales data to track property values. By contrast, the NCREIF Property Index, published by the National Council of Real Estate Investment Fiduciaries, uses appraisals to determine valuation trends.

“There are a lot of transaction costs to buying real estate. You've got to locate the property, negotiate it, and it's not easy to do standardized deals,” says David Blitzer, managing director and chairman of the index committee at S&P. “Once the derivative market is up and running, you'll be able to participate by going to the futures market. It's easier to get in, it's easier to get out.”

The Chicago Mercantile Exchange began hosting futures trading based on the S&P/GRA indices in October, and trading based on the Moody's/Real indexes should begin early next year. Blitzer expects the majority of real estate derivatives buyers will be institutional investors because licensing requirements place futures trading outside the expertise of the stockbrokers with whom individual investors are more likely to work.

Futures trading is already popular in the United Kingdom, where derivatives transactions avoid a 4% tax that is assessed on real estate acquisitions. In 2006, trading based on an index published by U.K. firm Investment Property Databank totaled nearly $8 billion. That equates to about 10% of commercial real estate investment volume in the U.K., Elkin says.

Data providers in the U.S. expect the concept to gradually gain traction here. Earlier this year, NCREIF inked agreements with four banks for a total of seven that provide derivatives trading based on its index.

Given that U.S. real estate transactions amounted to approximately $330 billion in 2006, there is the potential for tens of billions of dollars in domestic derivatives trading, says Elkin of Real Estate Analytics. “Once these tools are better understood, we'll go very quickly past that,” he says. “But we're not there yet.”

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