Given the seemingly endless stream of derivatives available these days-everything from pensioner longevity bets to more than 500 proprietary weather indices-it's remarkable that U.S. investors haven't had access to commercial and residential real-estate derivatives until now.
After all, domestic residential real estate was valued at $21.6 trillion at the end of 2005, with commercial valued at between $5 trillion to $7 trillion, compared with $17 trillion in stocks and $25.3 trillion in fixed-income securities, according to the Chicago Mercantile Exchange. "Real estate is probably the largest single asset class there is, and housing costs have [a] major influence on inflation, but the ability of investors to participate in real-estate values has been limited to owning properties or varying degrees of removed surrogates," says Michael Feder, CEO of Radar Logic, which recently launched proprietary real-estate indices for derivatives trading. "There's just not been a vehicle that allows investors to participate in real-estate value easily and with real liquidity. I think there's huge demand on the investment side for that."
Things kicked off in London nearly two years ago, but the American market for real estate derivatives has lagged. The CME was first to market in the U.S. in May 2006, offering futures contracts based on S&P/Case-Shiller Home Price repeat-sale indices for residential real estate. About $350 million of housing futures and options have traded on the CME since the launch, says Felix Carabello, CME director of alternative investments.
While the CME had a monopoly on U.S. real-estate derivatives for a year, a slew of new players is jumping into the over-the-counter market. Seven investment banks (Credit Suisse, Goldman Sachs, Merrill Lynch, and four unidentified others) have licensed the National Council of Real Estate Investment Fiduciaries' Index, also known as the NPI, and observers predict that up to eight more will join them soon. Meanwhile, Radar Logic entered the market in May, offering a daily spot price that reflects the sale prices per square foot of residential real estate in 25 markets. Other indices, with different methodologies and tracking different components of the real-estate market, include the Rexx Real Estate Property Index and the monthly RCA-based commercial-property index from the Massachusetts Institute of Technology's Center for Real Estate.
Advocates of residential-property derivatives argue that contracts based on the housing market make more sense than for commercial-property because it's triple the size; plus, because homes are bought and sold much more frequently than commercial buildings, the data can lead to greater accuracy in indices based on recent sale prices.
For lenders, a highly liquid and specific property-derivatives markets could be a risk-management godsend. Much of the seemingly endless boom-and-bust real-estate cycles are fueled by the relative inefficiency of the market. A healthy derivatives market could reduce transaction costs, increase liquidity, allow for shorting, and provide more accurate return-on-investment comparisons with stocks and bonds. Moreover, the availability of narrow property derivatives could be used to essentially reduce market risk, allowing for greater price competition. "It's really ripe for many different types of products," Carabello says. "If someone asks, 'Can you write me an option on a zip code?' I don't think the exchange will get that specific, but I have heard there's demand for that kind of specificity."
There may be lots of pent-up demand, but the quants behind the indices have to clear profit and intellectual-property hurdles before trading gets out of the gate. Trading on the CME has been light-usually about 30 to 40 contracts daily-hampered by S&P/Case-Shiller's decision to disallow contracts that stretch out further than one year. Carabello hopes that by the end of summer the CME will list contracts that hedge as long as four or five years. "That makes sense for a lot of investors," he says.
Similarly, Radar Logic's daily spot price has attracted significant attention, though some traders have balked at the licensing fees. The firm declined to provide figures. "It's the nature of the beast with housing," says Fritz Siebel, director of property derivatives at Tradition Financial Services. "It's hard to model all these things up."
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