Hedging Real Estate Risk_Real Estate Derivatives

8/14/2019 Hedging Real Estate Risk_Real Estate Derivatives

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Hedging Real Estate Risk:

Using Real Estate Derivatives


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Objectives

Understand the background and common types ofderivatives and discuss the types and uses of real estatederivatives

Discuss the real estate derivative products that arecurrently in use.

Discuss the mechanics of a real estate return swap Understand the risks involved in a real estate derivative Know how to use derivatives to reallocate and rebalance

a real estate portfolio Work through a hedge illustration using a return swap.

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Basics of Real Estate Derivatives


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Background on Derivatives

Derivative is a financial instrument whose value depends onthe values of other, more basic underlying variables.

For a real estate investor, the underlying variable would be thevalue of the real estate

The underlying variable is often a traded asset, such as a stock orcommodity, but it can also be an index.

For a real estate investor, the index may be the NPI, IPD or someother index

Derivatives are generally used as tools for isolating and pricingfinancial risks involved with holding the underlying variable.

For a real estate investor, the risk is that the value of their realestate holdings will decline.

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Common Types of Derivatives

Forward contract agreement to buy or sell an asset at a certainfuture time for a certain price. Is applied in direct real estateinvestment as a forward purchase agreement.

Futures contract similar to a forward, but deal terms are highlystandardized and contracts are traded on exchanges. These arenot commonly used in private real estate investment.

Option contract gives the holder the right, but not theobligation to buy or sell a specific quantity of an underlying assetat a specified price at some point in the future.

Swap two parties agree to exchange cash flows according to a

specified procedure, with no cash exchanged up front.

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Real Estate Derivatives

Based on composite real estate marketperformance as measured by indexes.

They offer a synthetic means to invest in theprivate real estate market.

The synthetic nature of the investment hasseveral attractive characteristics that may benefit

real estate investors.

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Source: Derivatives in Private Equity Real Estate by, Jeff Organisciak,Tim Wang, and David Lynn


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Hedging Risk: Applying Derivatives to RealEstate Investments

Hedging a commercial real estate portfolio using real estate(property) derivates involves either taking a short position on areal estate index using a total return or appreciation swap. Thisstrategy is similar to portfolio insurance and protects theportfolio from downside risks.

Real Estate derivatives can be used to effect asset allocation andrebalancing as a strategy that allows portfolio managers toexecute strategic or tactical asset allocation decisions in a fasterand more cost-efficient way than has ever been possible.

Real Estate derivatives can be also be used for speculation,

rather than hedging strategy that leverages the forward lookingviews and forecasts of a firm to take long or short positions.

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Benefits of Real Estate Derivatives

Quick Execution sourcing and executing private realestate investments is a time-consuming process. Propertyderivatives offer quick execution, which could benefitinvestors by allowing them to act on new information,strategies, or allocation preferences immediately.

Low Transaction Costs round-trip transaction costs ondirect investment are approximately 6-8% in the UK, and3-8% in the United States. Derivatives costs would belower and could therefore help to improve returns.

Short Positions taking a short position on the privatereal estate market has generally not been possible.Property derivatives enable the use of strategic hedging,which can protect the value of portfolios.

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Benefits of Property Derivatives

Flexible the size, length, and structure ofproperty derivatives contracts can be tailored tomeet individual needs. This gives investors

flexibility to meet specific investment objectivesand more easily achieve asset allocation targets.

Diversified because property indexes measure

aggregate market performance, investment inproperty derivatives does not include property orsite-specific risks.

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Real Estate Derivative Products andMechanics


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Source: Geltner & Miller, 2 nd Edition, South-Western

Real Estate Derives: Products CurrentlyOffered

NPI Appreciation Swap for Fixed NPI Total Return Swap for Fixed NPI Property Type Total Return Swap Similar products on IPD in U.K.

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Total Return Swap Derivatives: Mechanics

Motivation Investor A believes that the real estate index willoutperform the markets expectations and, therefore, wants totake a long position. Investor B believes that the index will underperform expectations and, therefore, wants to take a shortposition (either as a hedge on underlying real estate holdings or

as a speculative play). Pricing an investment bank (or other market maker) brings the

two sides together by setting a price: Investor A (long position) agrees to pay a fixed percentage rate

(offer) of a referenced notional principle amount (or receive arate if the quoted rates are negative) in exchange for a cash floethat is the index total return percentage of the notional amount.

Investor B (short position/hedge) agrees to pay the index totalreturn percentage in exchange for the fixed rate (bid).

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Total Return Swap Derivatives: Mechanics

Result investor B has locked in a fixed rate of return andis protected from the market performing belowexpectations in exchange for any potential upside.Investor A gains exposure to future market movements; ifthe market performs below expectations, he will losemoney, but if the market performs above expectations,he will make money.

The market maker profits from a spread between the bidand the offer rates.

Investor A is selling return insurance by participating in theupside. Investor B is buying return insurance by giving up the

upside.

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Risks in Derivative Products


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Liquidity Risk

Lack of market liquidity could seriously constrain amarket participants ability to sell a position at a fairvalue.

There may only be one bank active in making amarket for these products, if any.

Due to the low liquidity of the property derivativesmarket, the price discovery mechanism may not

function reliably. This could push market pricing tolevels inconsistent with property marketfundamentals or hypothetical swap marketequilibrium pricing.

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Counterparty Risk

The risk that the counterparty to a trade will nomake the expected payments

Exchange-traded markets eliminate virtually allcounter party risk by requiring daily cashsettlements.

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Source: Derivatives in Private Equity Real Estate by, Jeff Organisciak,

Tim Wang, and David Lynn


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Interest Rate Risk

Market prices of property derivatives areultimately based upon interest rates specificallyLIBOR (London Interbank Offered Rate).

Movements in interest rates will affect swapprices. Unless interest rate risk is hedged away, aswap contract contains an embedded bet on the

future direction of interest rates.

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Derivative Products:Reallocation and Rebalancing


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Allocation and Rebalancing

Inefficiencies in the private real estate marketmake strategic asset allocation difficult to executein a timely manner. Property derivatives offer

efficient access to real estate market exposure,which can facilitate more efficient portfoliomanagement strategies, such as diversification,asset allocation, and portfolio rebalancing.

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Diversification Diversify holdings regionally,internationally, or by asset class. Assembling a diversifiedreal estate portfolio is a very difficult, expensive, andtime-consuming process. An index offers diversificationthat is much faster and easier than direct investment,because the index tracks a large number of properties.Also, index exposure can be purchased in small sizes,where a diversified real property portfolio is inherentlylarge.

A diversification strategy would be most appropriate forsmaller portfolios that are heavily weighted in a fewregions or sectors due to their small size.

Accomplished by going long on commercial property indexwith a total return swap, buying futures, or buying options.

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Asset Allocation gain short-term access to specific assetclasses, regions, or markets based on macro level outlook.Portfolio managers who wish to make tactical investmentdecisions could use property derivatives to execute thesestrategies quickly and with minimal costs. It would be useful for

gaining access to specific regions, property types, or marketswhen acquisition of quality assets in the real property market isdifficult. The strategy would also be appropriate for disposition,as exposure to markets or asset classes can be reduced withouthaving to sell a trophy building.

This strategy would be appropriate for all funds regardless ofsize or scope.

Accomplished by going long or short on commercial propertyindex with a total return swap.

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Portfolio rebalancing adjust portfolio weights bysector or asset class to maximize risk-adjustedreturns. Based on portfolio analytics,recommendations can be made on adjustmentsbetween sectors or regions to move the portfoliocloser to its efficient frontier.

This strategy would be most appropriate for largediversified portfolios.

Accomplished by going long or short on a commercialproperty index, or swapping between two regional orsector specific indexes, using total return swaps.

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Illustration


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Hypothetical Portfolio Hedge

An investor with a hypothetical portfolio highly correlated to the NPIdecided to hedge the portfolio by taking the short side of an NPI capitalreturn swap in June 2007. At that time, the midpoint pricing to short theNPI capital return was 2.5% per year.

During third and fourth quarters of 2007, the hypothetical swap resulted innegative net cash flow, but the cash flow turned positive in the first quarterof 2008. Midpoint pricing for the NPI capital return declined from 2.5% inJune 2007 to -8.5%in July 2008. Because of this, the hypothetical futurecash flows became much more valuable, with a net present value of about$1.6 million (Exhibit 12.10). The investor can sell his position for a profit,unwind the position to lock in a fixed rate of return for the remainder of the

contract, or hold the contract until expiration. The proceeds of the hypothetical hedge transaction could go toward paying

investor redemptions, protecting a promote threshold, or supporting fundreturns.

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Quarterly Cash Flow for Short Position

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Notional amount: $10,000,000

Margin $300,000

Fixed spread: 2.50%

Term: 2 years Starting 9/30/07 ending 6/30/09

Quarter ending: 9/30/07 12/31/07 3/31/08 6/30/08 9/30/08 12/31/08 3/31/09 6/30/09

NPI Capital Return: 2.25% 1.86% 0.34% -3.07% -3.07% -3.07% -2.16% -2.16%

Fixed Spread: 0.63% 0.63% 0.63% 0.63% 0.63% 0.63% 0.63% 0.63%

Short side cash flows (receives fixed spread, pays NPI Capital Return)

Fixed Spread: $62,500 $62,500 $62,500 $62,500 $62,500 $62,500 $62,500 $62,500

NPI CR: $(225,000) $(186,000) $(34,000) $307,167 $307,167 $307,167 $215,625 $215,625

Net Cash Flow: $(162,500) $(123,500) $28,500 $369,667 $369,667 $369,667 $278,125 $278,125

Sum of past cash flows: $(257,500)

NPV of future cash flows: $1,577,406

Reported NPI returns shaded; implied NPI returns unshaded.


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Sources

Fabozzi, F., Shiller, R., & Tunaru, R. (2009) Hedging real estaterisk. Institutional Investor, Inc., Special Real Estate Issue 2009.

Geltner, D., Miller, N., Clayton, J., & Eichholtz, P. (2007)Commercial real estate: analysis and investments (2nd ed).Mason: Thomson Southwestern.

Contact: Cengage Learning, Inc.P.O. Box 6904Florence, KY 41022-6904

Lynn, David J. (2009). Active private equity real estate strategy.Hoboken: John Wiley & Sons, Inc.

Contact: John Wiley & Sons, Inc.111 River StreetHoboken, NJ 07030-5774

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