Wed Apr 4, 2007 10:24AM EDT
By Jonathan Keehner - Analysis
NEW YORK (Reuters) - U.S. brokers and exchanges are close to breaching an impasse that has prevented property derivatives from being widely available here, a step likely to be welcomed by increasingly jittery real estate investors.
While investors in nearly all other major asset classes enjoy the utility of a derivatives market, often to hedge their risk, those in fragmented and opaque U.S. real estate markets largely have not.
But access to real estate indexes is adding U.S. commercial and residential property ownership to the list of items, from companies' debtworthiness to the weather, that investors can speculate on through listed and over-the-counter markets.
Property derivatives are already widespread overseas, where the market for products linked to London-based Investment Property Databank indexes totaled 4.7 billion pounds ($9.2 bln) at year end. IPD's database has over 12,000 properties, or about half of the total property assets of U.K. institutions and listed property companies.
U.S. real estate, with over $270 billion in 2006 transactions according to Jones Lang LaSalle, has lagged behind for reasons including a lack of liquidity and reliable metrics.
"Each piece of property is unique so it's been hard to come up with measures that allow markets to be looked at on a macro basis," said Stephen Berkman of law firm Winston & Strawn LLP. "I think we're finally getting to where the information is being gathered and people trust the results."
In one move aimed at boosting liquidity, Credit Suisse Group (CSGN.VX: Quote, Profile, Research) recently relinquished its exclusive license to structure derivatives based on a property index compiled for nearly 30 years by the National Council of Real Estate Investment Fiduciaries.
The NCREIF Property Index (NPI) is an appraisal-based index measured quarterly, with nearly 5,500 institutional properties and a market value of about $250 billion at year end.
"Two years ago we knew very little about derivatives," said NCREIF Chief Executive Blake Eagle. "We have been on quite a learning curve ever since."
As a result of Credit Suisse's move, Merrill Lynch (MER.N: Quote, Profile, Research) and Goldman Sachs Group (GS.N: Quote, Profile, Research) are now also licensed, along with five other brokers, to structure NPI derivatives allowing investors to bet on whether the index will rise or fall.
"A lot of us are trying to make a bridge between derivatives and the real estate market," said Fritz Siebel of inter-dealer broker Tradition Financial Services. "But the market certainly knows NCREIF."
BROADER SEGMENT
New exchange-listed derivatives, which are standardized and centrally cleared, could also open real estate to investor segments like professional traders and smaller developers.
The Chicago Mercantile Exchange (CME.N: Quote, Profile, Research) last year launched housing derivatives based on the S&P/Case-Shiller Home Price Indexes and announced similar plans for commercial real estate with Global Real Analytics, a firm acquired by discount brokerage Charles Schwab Corp. (SCHW.O: Quote, Profile, Research) in January.
The Chicago Board of Trade (BOT.N: Quote, Profile, Research) has launched futures contracts on the Dow Jones U.S. Real Estate Index (.DJUSRE: Quote, Profile, Research), which consists mostly of real estate investment trusts.
"This goes to a broader segment that may be interested in real estate but lacks access to over-the-counter products, like professional trading shops, pension funds and small or mid-level hedge funds," said CBOT senior vice president Robert Ray.
Developers may look to real estate derivatives that are listed on financial exchanges to hedge projects, said Eric Loth of MA-based Northpoint Realty Development, which focuses on residential properties.
"A listed product with more liquidity, where you could jump in and out of the market, might be better for us as far as pricing models," he said.
Institutions seeking to hedge exposure to real estate stocks could also buy such derivatives, said John Capobianco of Susquehanna International Group, adding that portfolios exposed to homebuilders and REITs have been volatile.
SUBPRIME OPTIONS
An active derivatives market may help lenders reduce their risk to less creditworthy, or subprime, borrowers.
Winston & Strawn's Berkman notes that in commercial lending transactions, borrowers taking out variable rate loans are routinely required to buy derivatives called interest rate caps. These products become more valuable as interest rates rise, limiting a borrower's exposure.
"What if a lender made a loan accompanied by a product that made money if the property value went down, allowing the borrower to repay," Berkman said. "If subprime lenders could have done that they would be in much better shape today."
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