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in the four index-based contracts only lasted for a few months until the contracts plagued with illiquidity were withdrawn amid allegations of false trading.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 [ā¦]. Almost 25 years [after Shillerās 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 āan embryonic stageā (Tunaru, 2017). Lecomte (2007) argues that the main shortcoming of past attempts to launch property derivatives lies in these instrumentsā poor hedging effectiveness for direct real estate assets. Tunaru (2017) notes that āoverall the pace of financial innovation is very slow in this area [of real estate derivatives]ā. 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 āa different approach to identifying potential new marketsā. 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 Shillerās 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 estateās price dynamics.
