New Frontiers in Real Estate Finance

The Rise of Micro Markets

Patrick Lecomte

• Publisher: Routledge
• Year: 2021
• Print ISBN: 9780367361433
• eBook ISBN: 9781000395037
• Edition: 1
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

This book introduces three innovative concepts and associated financial instruments with the potential to revolutionise real estate finance.

The factorisation of commercial real estate with factor-based real estate derivatives is the first concept analysed in this book. Methodological issues pertaining to factors in real estate risk analysis are covered in detail with in-depth academic reference. The book then analyses the digitalisation of commercial real estate. The environment in which buildings operate is changing fast. Cities which used to be made up of inanimate architectural structures are growing digital skins and becoming smarter. Smart technologies applied to the built environment are fundamentally changing buildings' role in cities and their interactions with their occupants. The book introduces the concept of smart space and analyses the emergence of 'digital rights' or property rights for smart buildings in smart environments. It proposes concepts and methods for identifying, pricing, and trading these new property rights which will dominate commercial real estate in the future. Finally, the tokenisation of commercial real estate is explored. Sometimes described as an alternative to securitisation, tokenisation is a new tool in financial engineering applied to real assets. The book suggests two innovative applications of tokenisation: private commercial real estate index tokenisation and data tokens for smart buildings.

With factorisation, digitalisation, and tokenisation, commercial real estate is at the forefront of innovations. Real estate's unique characteristics, stemming from its physicality, trigger new ways of thinking which might have a profound impact on other asset classes by paving the way for micro markets. Factor-based property derivatives, digital rights, and tokens embody how commercial real estate can push the boundaries of modern capitalism and, in doing so, move at the centre of tomorrow's smart economies. This book is essential reading for all real estate, finance, and smart technology researchers and interested professionals.

1 The factorisation of commercial real estate

Factor-based real estate derivatives

Introduction: a brief history of real estate derivatives

As far back as recorded history goes, there is no evidence of the use of property derivatives until very recently. In fact, property derivatives did not exist. Mesopotamians could hedge the price of grain, barley, or red garlic, but they had no way to hedge the price of their houses (Swan, 2000).

In modern times, property derivatives were first introduced on the London Futures and Options Exchange (FOX) in London in May 1991 (Patel, 1994). Trading in the four index-based contracts only lasted for a few months until the contracts plagued with illiquidity were withdrawn amid allegations of false trading.

A few years later, Barclays Capital started to issue Property Income Certificates (PICs) akin to structured notes linked to Investment Property Databank (IPD) indices (all property income return and all property capital return). Almost GBP 800 million of PICs were issued in the 1990s. McNamara (2010) reports that from 1996 to 1998, Barclays Capital also issued Property Index Forwards (PIFs) designed after contracts for differences with returns linked to the IPD UK All Property Index.

In the early 2000s, after the Financial Services Authority and the Inland Revenue in the UK clarified their stances on property derivatives, interest for property derivatives was rekindled. By 2004, 21 investment banks acquired licences to commercialise IPD index-based property derivatives (Baum, 2015). IPD Total Return Swaps grew rapidly, reaching 265 contracts (GBP 3.5 billion notional) written in Q1 2008 when they fell victim to the subprime crisis (Torous, 2017).

Whilst the UK has been at the centre of property derivatives innovation (due to the serendipity of a well-organised property sector and innovative financial markets), the USA swiftly jumped on the bandwagon with the first NCREIF Property Index (NPI)-based swap agreement organised by Credit Suisse First Boston in January 2006 for US$10 million over two years (Fisher, 2005; Syz, 2008).

By October 2007, the Chicago Mercantile Exchange (CME) launched trading in futures and options on the S&P/Global Real Analytics Commercial Real Estate indices (Syz, 2008). Jud and Winkler (2009) note that the plan was to trade cash-settled commercial real estate futures in office, warehouse, apartment, and retail property sectors for all US regions with electronic trading out 20 quarters. This attempt to list direct real estate derivatives on standardised markets abruptly ended in December 2008 when the underlying index was no longer produced (Torous, 2017).

Meanwhile, in continental Europe, the largest European futures and options market, EUREX, listed IPD index-based futures. These cash-settled annual contracts were based on the total returns of MSCI-IPD UK quarterly indices. Starting with the UK All Property Index listed in February 2009, Eurex enlarged its listing in 2013 and 2015, by offering quarterly index futures on granular IPD UK indices (All property type x Region). Nine standardised futures contracts were open for trade until June 2020 when the market was shut down (Eurex circular 042/2020).

Despite the ebullient 30 years since the FOX Futures contracts were introduced, Tunaru and Fabozzi (2017) sound quite disillusioned with the actual success of property derivatives. They write:

Commercial real estate is directly linked to the real economy; by total size, it represents a significant spot market. However, it is still quite difficult for investors to hedge the risk exposure arising from investing in this important asset class […]. Almost 25 years [after Shiller’s Marco Markets (1993)], we are still waiting for standard derivatives such as such futures and options to be established as main contract with healthy liquidity.

As a matter of fact, in spite of the Global Financial Crisis, the real estate derivatives market is still in its infancy and has failed to develop beyond “an embryonic stage” (Tunaru, 2017). Lecomte (2007) argues that the main shortcoming of past attempts to launch property derivatives lies in these instruments’ poor hedging effectiveness for direct real estate assets. Tunaru (2017) notes that “overall the pace of financial innovation is very slow in this area [of real estate derivatives]”. Past research have focused on underlyings by looking at ways to improve the reliability of private real estate indices (e.g. Geltner, 1989). The problem with property derivatives stems not only from their reliance on direct commercial real estate indices, which do not capture the full range of idiosyncrasies in real estate risk at the granular level, but also and perhaps more importantly from their use of an index-based format.

Indeed, irrespective of the forms they have materialised into (e.g. Total Return Swaps, contracts for differences, listed futures contracts and options, structured notes), real estate derivatives have systematically been structured as index-based instruments using private commercial real estate indices (such as IPD indices in the UK or NCREIF Property Index in the USA) as underlyings. That is, they imply that private property indices are the optimal choice of underlying for a property derivative. The application of the index-based format of derivatives to commercial real estate supposes that whatever parameters led to the creation of index-based derivatives for equity portfolios also apply to commercial real estate. But, is it so? This chapter addresses this question and proposes two alternatives to the index-based format of derivatives in real estate finance: combinative derivatives and factor-based derivatives.

These two models of real estate derivatives epitomise what Shiller (1993) calls “a different approach to identifying potential new markets”. As this chapter explains, combinative derivatives have already been applied to other asset classes. Furthermore, factor-based real estate derivatives have been mentioned by Shiller (1993) in his analysis of macro markets applied to real estate:

One could imagine some factor analytic modelling to discover factors underlying variation in prices of claims on incomes, to enable contracts to cash settle on the basis of these factors.

This chapter reviews the notion of factors in classical finance and real estate finance. It describes the two new factor-based models of real estate derivatives proposed by Lecomte (2007) in line with Shiller’s early intuition. It then proposes solutions to overcome the difficulties inherent to the use of factor models. It concludes by reviewing the concept of stochastic process in real estate finance and devising a novel way to model commercial real estate’s price dynamics.

1 Factors versus indices

1.1 Models of derivatives and real estate risk

1.1.1 The perfect world of CAPM

The year 1982 was crucial in the history of modern finance with the introduction of index-based derivatives on US markets. The negotiation leading to this outcome was long and arduous with the first attempt to launch Dow Jones Futures dating back to the late 1960s (Brine and Poovey, 2017).¹ Against all odds, Leo Melamed, chairman of the Chicago Mercantile Exchange, managed to convince regulators that index-based futures contracts were not akin to gambling, but instead that they met a real need from investors and hedgers.

Index-based derivatives’ innovativeness results from two unique features: cash settlement and the use of a broad financial index as underlying. Both conceptually and historically, index-based derivatives are linked to the Capital Asset Pricing Model (Neiderhoffer and Zeckhauser, 1980). Bernstein (1995) notes that Capital Asset Pricing Model (CAPM)’s dominance in the financial industry following the 1973 oil price crisis provided some badly needed relief to investors unsettled by market turbulences.

Indeed, index-based derivatives were designed for the perfect world of CAPM’s normalities. They take care of systematic risk while portfolio diversification is supposed to reduce idiosyncratic risk to a negligible entity. CAPM’s reductionist approach to risk imposes on index-based derivatives a binary framework in terms of systematic risk/specific risk, which does not sit well with individual properties’ heterogeneity. Young and Graff (1996) sum up the dilemma facing real estate finance when applying Modern Portfolio Theory and its antecedent the Efficient Market Hypothesis:

MPT and EMH seem to have been introduced into real estate to justify the use of particular statistical techniques and portfolio strategies rather than as a consequence of empirical analysis of investment return and risk characteristics. In science, the situation is generally reversed: theories are developed to explain observations.

1.1.2 Real estate risk is different

As repeatedly mentioned in the academic literature (e.g. Weimer, 1966; Miles and Graaskamp, 1984), real estate has a number of idiosyncrasies which set it apart as an asset class from equities and fixed income: asymmetry of information, high transaction cost, illiquidity, importance of physical characteristics. Numerous evidence show that real estate fundamentally differs from CAPM’s perfect world (Clapp, Goldberg and Myers, 1994).

Since the early 1980s, literature on portfolio diversification has abundantly explored real estate risk. These studies focus on diversified portfolio’s risk, in particular as it relates to risk breakdown between systematic risk and specific risk. For instance, Miles and McCue (1984), Hartzell, Hekman and Miles (1986) indicate that systematic risk as defined in CAPM rarely exceeds 20% of total risk for a portfolio of buildings in the USA. Likewise, Brown and Matysiak (2000) who research the UK commercial real estate market identify that market risk accounts for less than 10% of the average fluctuation in a building’s total returns, versus 30% on average for a listed stock.

Bruggemann, Chen and Thibodeau (1984), Titman and Warga (1986) confirm these findings, and conclude that CAPM is not adapted to capture the risk/return relationship of direct real estate assets. As a result, researchers have explored other models more suited to explain real estate returns (e.g. Hoag, 1980). Some of these models are based on hedonic price regression described by Clapp and Myers as one of real estate’s fundamental paradigms. In terms of risk structure, the hedonic model is comparable to a multifactor model insofar as hedonic indices are made up of a range of hedonic variables whose individual contribution to the asset’s total utility makes up the asset price.

Whilst CAPM supposes that there is only one source of non-diversifiable risk captured in the market portfolio, factorial models acknowledge that risk might stem from multiple sources. The CAPM explicitly validates a mono-causal approach to real estate risk, whereas multifactorial models take into account various causes and their varying degrees of influence. The consequence of the index-based derivatives model applied to heterogeneous assets whose risk structure is not compatible with the CAPM is basis risk (Figlewski, 1984). In contracts for difference, a model which has been used for real estate derivatives, cross-hedge basis risk stemming from intrinsic differences between the asset returns to be hedged and the index price changes can become an insurmountable problem for hedgers and an obstacle to the smooth working of any standardised derivative market.

One cannot help wondering why real estate derivatives are, or have been, designed after a CAPM framework (i.e. using a composite index as underlying). A possible explanation is that there are no derivatives market capable of dealing with the myriad of factors that an instrument designed to address multiple sources of risk would entail.

1.1.3 The two realms of commercial real estate

Given the conceptual deadlock that composite index-based derivatives represent for real estate assets, an alternative model of derivatives using a hedonic index as underlying has been mentioned as part of Shiller’s macro markets (1993). Shiller’s model puts the spotlight on the true nature of commercial real estate. In a nutshell, when designing a derivative, shall a building be considered as a physical entity or as a financial asset?

Grissom and Liu’s analysis of the different paradigms in real estate sheds some light on this question (1993). Two models can be applied to commercial real estate:

• – A space-time model best defined by James A. Graaskamp (1976) and urban land economists before him, such as Richard U. Ratcliff (1949), and
• – A money-time model.

Any real estate investment aims to achieve the monetary cycle leading to the conversion of space-time into money-time, or...

Table of contents

• Cover
• Half Title
• Series Page
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of boxes
• List of figures
• List of appendices
• Acknowledgements
• Introduction
• 1 The factorisation of commercial real estate: factor-based real estate derivatives
• 2 The digitalisation of commercial real estate: smart space as real estate finance’s new asset
• 3 The tokenisation of commercial real estate: tokens as a new tool in financial engineering applied to real assets
• Final remarks
• Appendices
• Index