Property Derivatives Presentation

REAL ESTATE DERIVATIVES
Real Estate Derivatives
A presentation at
NYU Schack Institute of Real Estate
Stephen R Gould
February 3rd, 2010
This presentation is for informational purposes only, from sources believed by Vyapar Capital
Market Partners LLC to be reliable. Vyapar Capital Market Partners LLC does not represent that
the material contained herein is accurate nor that any products mentioned are available either as
described or at all. Nothing contained herein should be regarded as or construed as a trading or
investment recommendation. All materials contained herein may be reproduced provided they
are properly attributed.
Contents:
3. Review of property indices

7. Review of derivative products
14. Use of derivative products by end-users
22. Theoretical case study
25. The unaccountable failure of the US real estate derivatives market
to develop as in other countries
28. Appendix 1: US commercial index coverage
29. Appendix 2: US residential index coverage
30. Appendix 3: VCM and real estate derivatives
2
1. Review of property indices
METHODOLOGY
The general principle of index calculations is the same in real estate as elsewhere:
Index return% = Value at end of period ÷ Value at beginning of period - 1
There are particular problems with real estate

► Most real estate does not trade within index measurement periods
► Value of an individual building depends not just on land and building value, but rental
agreements in force, etc.
► (Particularly for residential) Allowance may be needed for any improvements to property,
e.g., building appraised at $100mm, and developer rewires, retrofits for energy efficiency,
etc.; or 3-bedroom house bought for $200,000 and extension costing $50,000 is added.,
Still, this is simply a conspicuous demonstration of my Index Theorem:
“The only accurate index is where all the assets underlying the index are traded at the begin-
ning and at the end of the index measurement period and no change to the assets takes place
in the mean time”
All other indices are modelled or import assumptions

► E.g, S&P500 assumes that the price at which the last shares traded at end of day is the
same price at which all the shares of a company would trade. Is this a reasonable assump-
tion?
3
1. Review of property indices—index types
Appraisal-based
The commonest form of real estate index, where property values are determined by appraisal,
reported to the index provider, and the calculation of index proceeds as above.
Commonly, appraisals of US institutional investment properties are made every quarter, but
not always from external appraisers.
And there is no guarantee that appraisals reflect real values - there is some evidence that ap-
praisers are “conservative”, particularly in declining markets.
Transaction-based
As the name suggests, values are determined by actual transactions. In the case of real estate,
the transaction price is often converted to a “dollars-per-square-foot” pricing, to allow for
comparability, and to avoid the problem of a single property only being traded once in a
measurement period—so how did its value change?
Repeat sales
Repeat sales methods—which are by definition transaction-based—look at the return on indi-

vidual properties which are actually bought and sold, and thus they avoid the problems inher-
ent in appraisals.
Nonetheless there are still the questions of improvements or diminutions between the pur-
chase and the subsequent sale.
(For those of you so minded, google “hedonic regression”.)
A repeat sales method does not instantly give you a short-term return or value: if a house is
bought in 2002 and sold in 2007 for a 50% profit, that return of 50% has to be amortized over
5 years, and there is no immediate way of saying what happened to real estate prices over the
recent quarter. However this problem is solved when one is dealing with a large number of
repeat sales thus: suppose two representative houses were bought on the same day in 2002. If
the first house is sold for a 50% profit after 5 years, the second house is sold for a 55% profit
after 5 ¼ years, then you can see that the last ¼ year saw a rise of 5%. And as more and more
houses are included in the database, the calculation becomes progressively more accurate and
reliable.
4
1. Review of property indices—index providers (commercial)
INDEX PROVIDERS - Commercial
NCREIF
The National Property Index (NPI) is an appraisal-based index that is produced quarterly by
valuing the properties in the NCREIF database. This is the benchmark for the US pension
fund industry. NCREIF reports income, capital and total return indices for the NPI
http://www.ncreif.com
IPD
In 2009 IPD launched an index series for US commercial property. As with their other indi-
ces, their US indices are appraisal-based. IPD have stated that at present they have no interest
in licensing their US indices for use as the underlying in derivatives contracts.
http://www.ipd.com
ReXX
Total Returns are produced quarterly and calculated for the US Office market based on lease
transaction prices, asking rents, Effective Fed Funds and CPI. It has some conceptual simi-
larities with CAPM and APT.
www.rexxindex.com
Moody’s/Real CPPI
This is a joint venture between Moody’s and Real Capital Analytics. Transaction data is
sourced from NCREIF and elsewhere, using deals over $2,500,000 in value. Moody’s/Real
uses the repeat sales method.
http://www.rcanalytics.com/derivatives_index.aspx
(The data underpinnings for Moody’s/Real come from the MIT Center for Real Estate, which
produces its own index, MIT-TBI. It is not marketed as the underlying for derivatives.)
Comparisons
One can, somewhat glibly, sum up the major indices thus: “NPI is what we think happened,
Moody’s/Real is what actually happened, and ReXX is what should have happened”. Suffice
it to note that NPI is down 24% from its peak while CPPI is down 43% from its peak.
5
1. Review of property indices—index providers (residential)
INDEX PROVIDERS - Residential
S&P/Case-Shiller
The Home Price Indices are produced monthly by a joint initiative of S&P and Fiserv. The
index uses repeat sales methodology. Indices for 20 major metropolitan areas (MMAs) plus
10-city and 20-city composites of the individual MMAs are reported monthly. Indices avail-
able include a National Index, reported quarterly, nine US census divisions, etc.
http://www2.standardandpoors.com
Futures and options on S&P/Case-Shiller are traded on CME
Radar Logic (RPX)
RPX provides 1-day, 7-day and 28-day index prices for many metropolitan areas. The index
was launched in 9/07. A proprietary model is used to convert data into results, reported as
price in dollars per square foot.
http://www.radarlogic.com
Comparisons
S&P/Case-Shiller has the pedigree, RadarLogic has the advantage of more effective market-
ing to Wall Street.
(Shiller has analysed the RadarLogic methodology and found that as applied to stocks it did
not replicate the performance of the S&P500 index, which methodology is essentially unim-
peachable. This led him to conclude that the RadarLogic approach is deficient.)
6
FORWARD CONTRACTS
► Agreed-upon notional amount:

e.g., $25,000,000
► Agreed-upon settlement date:
e.g., 12/31/10
► Agreed-upon underlying index:
e.g., S&P/Case-Shiller National Index
► Forward price agreed on inception.
► Forward transaction is cash-settled on settlement date

i.e., a “contract for differences”.
Example
► $25,000,000 forward from 6/1/10 to 12/31/11

► Priced off S&P/Case-Shiller National Index
► Settlement price of 175 agreed at inception
On 2/24/12, the index release (for end-Dec 11) is 185.
Payment: (185/175 – 1) x $25,000,000 = $1,428,571 to buyer of forward.
If price had fallen below the settlement price, the buyer would have had to pay to the seller on
expiration.
The settlement price determined by factors like current index price, projected rents, financing,
etc.
FUTURES CONTRACTS
Futures are not fundamentally different from forwards. Major distinctions

► Contract sizes standardised
► Settlement date standardised
► Legal counterparty is exchange
► “Mark-to-market” requires payments to be made (or received) over the life of the contract
as the price fluctuates.
7
OPTIONS
Options on RE indices, like forwards, are cash-settled.
Example:
► 220 6-month call on S&P/Shiller NI on $10,000,000 notional, premium 0.50% = $50,000
► If index is below 220 in 6 months, option is worthless

► If index is above 220 in 6 months, buyer receives:
$10,000,000 x (Index/220 – 1) in cash.
Payoffs/P&L
Index finishes at:

250: (250/220 – 1) x $10,000,000 - $50,000 = $1,313,640
235: (235/220 – 1) x $10,000,000 - $50.000 = $631,820
215: no exercise, loss $50,000
200: no exercise, loss $50,000
Not yet traded, but due, are swaptions—options to enter into total return swaps (see p10).
8
2. Review of derivative products —Options
Option payoff
9
TOTAL RETURN SWAPS
RE Index
Total Return%
Party A Party B
Fixed rate
Example:
Property owner A and investor B agree to enter into a
► $25,000,000 swap of
► NPI versus 4%
► Deal date 1/15/10
► Start date: 12/31/09
► End date: 12/31/11
Every year (or every quarter), A pays B the cash value of total return of the index for the year
on the notional amount Every year, B pays A the cash value of the funding leg rate on the no-
tional amount.
The Index return for the year is calculated thus:- Final index 12/31/10 (reported 1/25/11) di-
vided by Initial index 12/31/09 (reported 1/25/10) minus 1.
(NCREIF and many other indices typically report both index values and index returns, so usu-
ally the index return need not be calculated separately.)
By agreement, the notional value either remains constant over the life of the swap, or is ad-
justed up or down after each payment period by a factor equal to the index return, e.g., if the
index rose 2% in the first year of the swap above, the notional would be increased by 2% to
($25,000,000 x 1.02), $25,500,000 notional.
Not yet traded, but due, are amortising and accreting swaps. In the former case, the notional
amount decreases to a specified schedule, in the latter, the notional increases.
10
Swap payoff
On 1/25/11, NCREIF reports an annual return for 2009 of 2.5%
► Owner A is due to pay investor B that 2.5% on $25,000,000 = $625,000

► B is due to pay A the funding rate of 4% on $25,000,000 = $1,000,000
► Payments are netted out before actual transfer of cash
► B pays A net: $1,000,000 - $625,000 = $375,000
► Payment is made two business days after NCREIF report result
The effect of the swap is that A, the owner, has eliminated his exposure to $25,000,000-worth
of real estate. Effectively, he has sold $25,000,000-worth and invested the proceeds at 4%,
but will reacquire the exposure at the end of 2011 at the market level prevailing then.
And B, the investor, has gained the equivalent exposure to the real estate market. Effectively,
he has bought $25,000,000-worth of real estate, funded himself at 4%, and he will be unwind-
ing his position at the end of 2011.
Negative swap rates
In most swap markets most of the time, swap rates are positive. One counterparty pays the
funding leg (fixed or floating) and receives the index return from the other.
In Real Estate swaps, owing to current negative expectations for the underlying indices, swap
rates are presently negative. Paying a negative rate means that one actually receives the rate.
E.g., 2-year NPI vs. -10%

Someone receiving the return on the NPI for two years “pays” -10%, i.e., receives 10% a year
This makes sense if market participants expect NPI to fall 10% a year (at least) for two years.
For then, the receiver of the index return will actually be paying on the index leg as the return
will be negative. If A is due to pay B –10%, then B actually will pay A 10%.
Negative swap rates make sense (they’re like backwardations in commodities) but they can be
confusing and are counter-intuitive
11
PRICING PROBLEMS
Forwards, futures and swaps
In pricing theory, forwards and futures on an asset are priced relative to the spot price as a
function of carry costs, insurance and other holding costs, and expected cash generation of
that asset. The forward and future pricing is constrained by no-arbitrage requirement:
► if the forward price is too low, short the asset today (“spot”), buy it forward, and in the
mean time put the money on deposit. Proceeds from maturing deposit are used to pay for
the forward, and there will be a net profit.
► If the forward price is too high, borrow the money to buy the asset spot, sell it forward,
use forward proceeds to repay loan, and receive a net profit.
Theory only works if

► transaction costs for buying asset spot and selling it forward are low, and
► one can sell short the asset spot.
Real estate has high transaction costs and cannot be shorted. Hence the theoretical pricing
approach does not work. Instead, pricing is based on actual market expectations.
Swap pricing follows forward pricing—with a few more wrinkles. But the same overall prin-
ciple applies.
Options
Traditional financial option models should not be expected to work on real estate.
Assumptions of traditional models:
► Returns (log-)normally distributed (for Black/Scholes-type models)
► Transaction costs are low
► Underlying can be shorted
None of these are true for real estate.
Hence either
► model the way real estate does perform, e.g., high degree of correlation with previous
quarter, and price it as the statistical expectation value of the option, or
► put a utility value on the option based on estimate of the bet the trader is prepared to make
or the buyer (or seller) is content to trade on.
12
EXCHANGES
Exchange-traded
While most RE derivatives trade over-the-counter (OTC), there are some exchange-traded
futures and options contracts
Traded on CME
S&P/Case-Shiller futures and options
Traded on Eurex
IPD futures and options—UK, France and Germany
Traded on ISE (Eurex subsidiary)
ReXX options
Exchange-cleared
Having derivatives clear through an exchange eliminates counterparty risk, which can be a
source of anxiety in OTC contracts. But exchange clearing requires counterparties to put up
performance bonds – akin to escrow accounts.
13
INITIAL CAVEATS
Some strategies/products may require the portfolio to make net payments to a counterparty.
If the derivative trade works on a portfolio level, then an economic profit will be found else-
where within the portfolio. But economic profits do not necessarily generate cash. Hence
occasionally some form of standby facility or funding reserve may be prudent/necessary and
may be required by counterparty (ref ISDA's Credit Support Annexe.) Or else, some form of
escrow account can be used, akin to margining.
Though RE derivatives are not yet liquid in comparison to other financial assets, liquidity
takes time to build, and the derivatives may never be quite as liquid as major fixed income or
FX derivatives. But nonetheless we believe they are still likely to become liquid in compari-
son to real assets. Even now it is faster to execute a trade on $200mm notional of an NPI
swap than $200mm of diversified commercial property.
14
Buying protective puts
► No easy way to hedge downside exposure in the cash market

► In some asset classes, protective puts are seen as too expensive
► Low volatility of property indices = low cost of option
However, note Caveat at end of section.
Total return swaps
Paying the index is equivalent to liquidating exposure for the notional value, and
for the term of swap e.g., a 3-year $50mm TRS eliminates exposure to $50mm-worth of di-
versified property for 3 years.
After the maturity of swap, exposure returns
The swap allows investors to time the market if so desired. If your model suggests that prop-
erty will be weak over next 3 years, the traditional approach would require that you liquidate
now, and attempt to find equivalently desirable properties in 3 years, if you assume that you
are able to invest immediately after 3 years. Hence you may in practice reluctantly do noth-
ing.
Using derivatives, you enter into a 3-year swap. If you change your mind, e.g.,
market will strengthen before 3 years, then unwind the swap, or if you think that the market
will stay weak, you can enter into another swap.
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Amortizing swaps
An amortizing swap can be used against a projected liquidation schedule.
Example:
An investor wishes to liquidate $40mm of assets. Experience suggests that approx. $10mm
can be sold on average every 6 months - ergo exposure remains but declines over two years.
A 2-year $40mm swap amortising at $10mm every 6 months reduces exposure - and gener-
ates a funding leg cash return which can be used by client to get exposure to fixed or floating
rate markets (or indeed, other assets.)
Accreting swaps
Accreting swaps can be used where an investor wishes to retain general market exposure, but
wants to take advantage of specific selling opportunities.
Example:
A property owner sees the likelihood of selling a few prime buildings at very advantageous
prices over next two years but does not want to reduce overall market exposure nor can com-
mit to buying other property owing to timing difficulties.
A 2-year accreting swap, accreting at $Xmm every 6 months, is equivalent to increasing in-
vestment by $Xmm, $X determined by approximate liquidation schedule.
Another possibility is a 3-year or 4-year accreting swap, accreting only over the first two
years, and thereafter, the swap is gradually unwound as new property is purchased with pro-
ceeds from sale of existing property.
Swaptions
Swaptions may be used to extend or shorten an existing swap, e.g., no good opportunities
have been found in next three years but exposure still desired, so it may make sense to enter
into a new swap, and a swaption fixes the funding leg rate now
Perhaps opportunities to invest occurred more rapidly than expected, and therefore a swap
may not be needed for its full term, and a swaption can fix the unwinding rate now, rather
than at the later market-prevailing rate.
16
Leveraging
Receiving index return on a swap, or buying a forward is equivalent to leveraging if the port-
folio is already invested. It may be more economical/advisable for an investor to leverage
thus than through leveraged acquisition of property
Instant Exposure
Derivatives permit immediate exposure.
► Buying forwards and swaps

is like investing instantly in real estate. It is equivalent to leveraged exposure unless
investor has cash in hand equal to notional.
► Buying calls
if the forward price is relatively low, calls can be a cheap way to get upside exposure
► Accreting swap
If new cash will be entering the portfolio to a pre-arranged schedule, an accreting
swap with accretion matching that schedule permits immediate exposure as cash en-
ters.
17
Lenders and bond-holders
The owner of a property backed loan or bond is already short an implicit put on the value of
the collateral. Consider that if the property appreciates, the lender still only receives 100% of
face value (assuming no additional non-standard features on the debt), but if the property de-
clines sufficiently, the loan will be worth progressively less and less— a payoff profule just
like a short put.
And the way to hedge a short put is, of course, to buy a put. So in theory an investor in prop-
erty-backed debt can hedge the property risk by buying a put on a relevant index; and if the
cost of the put is less than the present value of the additional per annum return by investing in
such a risky asset rather than high quality debt, an economic profit results.
For example, an investor can buy a 5-year UST bond for a yield of 3% at par, or a 5-year
property backed note for a yield of 8%, also at par. He can buy a put which hedges out the
property exposure for 10%. Even by inspection, without resorting to a financial calculator,
one can see that the extra yield on the note easily pays for the cost of the put.
(The transactions like this that have occurred have tended to use forward contracts—selling
them, clearly— rather than puts owing to greater liquidity of forwards, and the willingness of
the loan buyers to accept the slight risk of the property market recovering substantially.)
Non-property corporations
The reality is that most large corporations need buildings! And if they own their buildings, a
decline in value will affect the NAV of the corporation even if there is no direct impact on the
Firm Valuation, which will in turn affect their capacity to obtain secured loans. Further, some
equity analysts use metrics like Tobin’s Q to judge fundamental corporate valuation, and not
having had the benefit of being taught equity valuation at NYU by Prof. Damadoran, will tend
to make adverse recommendations concerning the stock.
Alternatively, a corporation will lease its properties to avoid the capital risk; but then they are
in effect short commercial property, as when the time comes to renew their leases, the new
lease cost will be driven significantly by the value of the property at time of renewal.
If a company leased a $100mm property when cap rates were 8%, so paying $8mm a year,
and on renewal the property is worth $200mm, though cap rates are now 6%, they will be
paying $12mm. (From an attribution perspective, $16mm of that $12mm was due to their be-
ing short property, with a $4mm profit due to being long “cap rate duration”.)
18
In the case of owning their property, they could hedge by selling forward contracts or paying
the index leg on a swap, and in the case of leasing, they could hedge part of the exposure (cap
rate not yet being hedgeable) by doing the opposite.
The practical problem for corporations doing this (in addition to the basis risk described later)
is that losses on buildings or economic losses on lease renewals do not appear as additional
cash flows (in the latter case, they would be understood by investors). But losses on the
hedge require actual cash payments to be made, and investors and shareholders tend to be un-
comprehending when a company argues that a physical cash loss is offset by an economic
gain, regardless of how valid the argument.
19
PROBLEMS, SOLUTIONS...
Problem: investor wishes to reduce exposure in RE rapidly

Solution: pay index on TRS, unwind swap as property is liquidated
Problem: RE market looks choppy – downside protection desired without losing upside
Solution: buy protective put on index
Problem: investor bearish into the medium term but has quality assets – difficult to replace if
sold
Solution: pay index on TRS to horizon of bearish view - investor retains assets but has
largely eliminated market exposure
Problem: investor wishes to liquidate to schedule, use proceeds to invest generally in other
financial or commodity assets
Solution: amortizing swap as per liquidation schedule - funding leg can be used as cash flow
in swap to give client synthetic exposure to other asset classes until proceeds are available.
Problem: investor sees possibility of selling some specific properties in the medium term at
advantageous conditions, but does not want to eliminate exposure to market
Solution: accreting swap, receiving index, with notional amount rising; or swaption .
Problem: investor considering liquidating specific assets but wants the flexibility to retain
market exposure
Solution: buy a swaption (or swaptions) to receive index – if investor liquidates, exercises
the swaption(s) as property is liquidated.
Problem: investor likes market, to the extent that he is considering leveraging

Solution A: buy index forward
Solution B: receive index on TRS
Problem: new cash available for investment, investor does not want to delay exposure but
does not want to have to buy just what is available now
Solution A: buy index forward, unwind forward as property is acquired
Solution B: receive index on TRS, unwind swap as property is acquired
Solution C: if pricing warrants it, buy call on index
Question: how many of these problems could be solved without the use of derivatives ?
20
CAVEAT 2
“The only perfect hedge is found in a Japanese garden”
► Hedges – and proxies – are not perfect

► No real portfolio is identically structured to any index
► No index nor derivative can accurately represents the bricks-and-mortar underlying
But in general an imperfect hedge or proxy is better than none; and an inaccurate low-cost
strategy may be better value than a more accurate but high-cost strategy.
HOWEVER—owing to the practical impossibility of shorting the spot index, derivatives will
“price in” future expectations while current property prices might not.
► So a hedge can end up locking in the very event you want to hedge against.
21
4. Theoretical case study—a property developer’s use of derivatives
A property company prides itself, justifiably, in finding undervalued brownfield sites which it
can subsequently develop. Suppose it buys some land for $45mm which it knows should be
worth $50mm. But over the next year as it begins developing, local commercial real estate
values fall by 20%, so that their property is now worth a realizable $40mm.
Even though they bought the land for 10% less than the market value, the decline of the mar-
ket overall wiped out the benefit of that cheap acquisition and more.
Suppose, instead, that at the time they acquired the property, they had paid the index on a total
return swap (TRS) against receiving 4% annual fixed (the funding leg) for 1 year, the index
being a regional commercial index appropriate for the site.
They decided to trade a notional amount of $50mm, being the value of the property, not the
acquisition cost.
Now compare the year-end results.
At year-end:
Unhedged:
Loss on land: -$5mm
Hedged:
Loss on land: -$5mm

Index leg on swap -$50mm x -20% = $10mm rec’d
Funding leg: $50mm x 4% = $2mm rec’d
Total: $7mm
So by putting on the TRS, they have eliminated their exposure to declining real estate values
and have locked in the benefit of buying the undervalued property.
Of course, it is always possible that real estate rose. What if property overall had risen 20%
and the land was now worth $60mm ?
22
Now the year-end results look like this:
Unhedged:
Profit on land: $15mm
Hedged:
Profit on land: $15mm

Index leg on swap -$50mm x 20% = -$10mm (paid)
Funding leg: $50mm x 4% = $2mm (rec’d)
Total: $7mm
Because they hedged, they did not get the benefit of the rising market. However, the com-
pany may not be as concerned by missing out on a possible gain as eliminating the risk of a
possible loss.
If the company’s added value to its owners is the ability to spot undervalued land, the TRS
hedge strips out the non-added-value element of the investment, namely the exposure to the
overall market.
It is an old truism that one of the functions of risk management is to eliminate the risks that
you do not want to take. Here, by using the TRS, the company has done so, and is now ex-
posed, so to speak, only to its core competence. Note that the shareholders are unlikely to be
impressed if the company’s managers were to report that they did not lose as much as they
might have done because their land investments did not fall as far as everyone else’s.
Consider a property developer who, again justifiably, prides itself on its expertise, in this case,
of development itself. Owing to its competence in quantity surveying, professionalism and
productivity of workforce, etc., its cost of construction is somewhat lower than its competi-
tors.
Experience suggests that if it buys a site for $100mm, and spends $50mm (in present value
terms) in construction, it can sell the resulting property for $225mm, when its competitors
would normally spend $65mm, provided there is no change in property prices; and it takes
two years from purchase to sale. Hence they would expect to earn $75mm on an investment
of $150mm, 50%, while its competitors would earn $60mm on an investment of $165mm,
36%.
23
Now if property prices drop by 20% from acquisition to sale, they will sell the property for
$225mm x (100% - 20%), $180mm, a profit of $30mm, or 20%, over two years. If their cost
of capital or hurdle rate is 15% per annum, (for quick calculation purposes equivalent to a
cash value of $45mm), then notwithstanding their expertise at development, the overall pro-
ject will have been unprofitable.
Suppose there is a suitable two-year index forward contract with the spot at 500 and the for-
ward at 560 bid. The company hedged by selling a notional amount of $225mm x (560÷500),
$$252mm. (In practice they may round to $250mm). If the market is down 20% over two
years, the index will close at 400. The company’s position will thus be:
Profit on sale: $30mm

Economic cost of capital: -$45mm
Profit on forward:
$252mm x (1-400÷560) = $72mm
Total P&L: $57mm
Alternatively, property prices rose 10% over two years, so the building sells at $225mm (1+
10%), $247.5mm and the index closes at 550.
Profit on sale:
$247.5mm - $150mm = $97.5mm
Economic cost of capital: -$45mm
Profit on forward:
$252mm x (1-550÷560) = $4.5mm
Total: $57mm
Hence by selling the forward contract the company has eliminated exposure to the real estate
market while retaining its exposure to its core added value, its ability to develop relatively
cheaply.
Note that they made $57mm by hedging, though unhedged, they would have made $75mm in
an unchanging market.
The reason for the difference between the $75mm and the $57mm is that their hurdle cost of
15% p.a. is somewhat higher than the implied return on the forward contract, which is
(560÷500 – 1), 12% or roughly 6% p.a. By selling the forward contract, they were in effect
lending funds at 6% while simultaneously borrowing at, or at least, requiring a return of, 15%.
24

THEORETICAL EXPLANATION
When a derivatives market begins operating, keys to that market include a useful and reliable
index. Part of the utility of the index comes from how large the basis risk, i.e., the risk of dif-
ferential performance of the index versus the assets for which the index is a proxy.
As the basis risk rises, the effectiveness of a hedge falls (like hedging fewer and fewer stocks
with a broad stock index and so the specific risk rises).
In places like the UK, 40% or so of the IPD index of UK commercial properties can be found
in a relatively small area around London, bounded by the M25 motorway. (This is almost as
if 40% of the NPI could be found in the Tristate area.)
But in the US, Class A commercial property is very broadly distributed. A developer in NYC,
using an NPI derivative to hedge, is exposed to the commercial property market in Boston,
Chicago, San Francisco, Los Angeles, Houston, etc.
Hence the basis risk for US national indices is relatively high, and that retards its theoretical
effectiveness as a proxy for specific desired or to-be-hedged exposures.
PRACTICAL EXPLANATIONS—rational
In practice there are other problems. For example, there is a temporal basis risk due to the
appraisal process. The NPI typically lags actual market appraisals, and hence while in the
long run the tracking error will not matter much, as trend swamps fluctuations, in the short
run the error may be significant, as fluctuations dominate trend. This suggests that using an
appraisal-index-based derivative of a short tenor will have a high basis risk.
In the case of residential derivatives, the failure to develop into a sizable market is straightfor-
ward. Who is the natural buyer of a residential derivative? The answer is, apart from a few
traders specialising in obscure mortgage-backed structures, no-one.
There are certainly some buyers on speculative grounds, but for a market to become solidly
established, you need natural buyers, who will buy when prices are fair or even perhaps a lit-
tle rich. If they are not there, the market cannot develop long term.
There is also the Catch-22 that many potential market participants have said that they would
be active if the market were liquid. (Typically, everyone in a market thinks that everyone else
25

is the market.) This was broken in the UK by two or three major property companies who
decided that it was in their interest for a derivatives market to develop. They “primed the
pump” of the market by doing transactions simply to get the market going, hence creating li-
quidity which in turn attracted other participants.
This worked in the UK because there are such companies which represent a significant frac-
tion of the property investment community. No three property companies in the US are to-
gether large enough to generate the needed liquidity.
Or so it is claimed.
PRACTICAL EXPLANATIONS—irrational
The important issue in firing up the market is not whether there are those few huge players,
but how liquid the market needs to be compared to the size of the major players. The reality
is that there are plenty of potential actors who are themselves large enough to generate the
liquidity required.
A derivatives market of $10bn is already sizable enough for people to take note, for investors,
hedge funds, etc. to be confident that in trading $50mm here or $100mm there they could
close out rapidly enough for comfort. And there are plenty of property investors and prop-
erty-orientated funds who could get involved to raise liquidity beyond that necessary to get
the market up and running.
For many major investment institutions, derivatives are less interesting than physical property,
and they cannot charge as much in management fees for that part of their portfolio consisting
of derivatives as for the physical portfolios. So what are the personal and corporate incentive
for them to get involved in the market? One can show such institutions a derivatives strategy
which will allow them to beat their investment benchmark by say 10%; but if the institutions
think that they can beat the benchmark by 4% anyway, and charge 2% for managing an inter-
esting portfolio, while adopting the strategy is boring and they can only charge 1%, and they
will not get punished by their clients for not taking advantage of the derivatives, they will
continue to shun derivatives.
Now their clients may think that these are inadequate reasons—if they are made aware of it,
but until the consultancy companies which advise pension funds, endowments, etc. start draw-
ing these clients’ attention to what their managers are doing, or until these consultancies real-
ise that they cannot afford to keep recommending as managers institutions which are not in-
terested in maximising the performance of their clients’ portfolios there will be no incentive
26

for the investment management firms to change.
As far as residential derivatives are concerned, though there are, as indicated above, rational
reasons for the failure to develop, there is one major irrational reason, which is that for rea-
sons which the writer will not commit in print, the Wall Street trading community adopted the
wrong index: rather than using the established and strongly branded S&P/Case-Shiller index,
they adopted the novel, unbranded and highly proprietary RadarLogic index.
27
Appendix 1: US Commercial Index Coverage
NCREIF ReXX (Office only)
National Property Index (NPI) US Office (All Market)

Office Atlanta
Industrial Boston
Retail Chicago
Apartment Dallas
Hotel Denver
West Houston
Midwest Los Angeles
South Miami
East NY Midtown
NY Midtown South
Moody’s/REAL NY Downtown
Phoenix
Commercial Property Price Indices (CPPI) San Francisco
cover: Seattle
National Washington DC
Top 10 MSAs per sector
West
East
South
So. California
in
Apartments
Industrial
Office
Retail
And also cover

New York Office
San Francisco Office
Washington DC
Florida Apartments
28
Appendix 2: US Residential Index Coverage
S&P/Case-Shiller Radar Logic
Single family 25 MSA Composite

Atlanta
National Home Price Index (NI) Boston
Composite-10 (10 largest) Charlotte
Composite-20 (20 largest) Chicago
Atlanta Cleveland
Boston Columbus
Charlotte Denver
Chicago Detroit
Cleveland Jacksonville
Dallas Las Vegas
Denver Los Angeles
Detroit Miami
Las Vegas Milwaukee
Los Angeles Minneapolis
Miami New York
Minneapolis Philadelphia
New York Phoenix
Phoenix Sacramento
Portland San Diego
San Diego San Francisco
San Francisco San José
Seattle Seattle
Tampa St. Louis
Washington DC Tampa
Washington DC
Condominium
Manhattan Condo
Boston
Chicago
Los Angeles
New York
San Francisco
29
Appendix 3: VCM and Real Estate Derivatives
Vyapar Capital Market Partners LLC is a client-focused interdealer brokerage

firm that strives for excellence in a range of OTC wholesale derivative products.
Vyapar’s focus on non-commoditized products like real estate derivatives, and its
approach to growth, are unique. In focusing on products in the early to middle
stages of their life cycle.
In these products, clients expect a depth of product knowledge and excellence in

overall decision support, and the ability to analyze the clients' needs in depth:
Vyapar’s strategy is designed to meet those requirements.
Vyapar provides intermediary broking services to clients in the wholesale finan-

cial markets to draw together liquidity and establish pricing to match buyers and
sellers so that deals can be executed. Vyapar provides service based on high stan-
dards in all levels including market information, trade execution, and enabling
technologies coupled with maintaining client anonymity.
Our unique partnership culture, built upon our ‘One Firm’ philosophy, promotes
collaboration across our businesses and results in a close alignment with the needs
of our clients. Vyapar’s high standards of excellence, client focus and partnership
culture drive the consistent long-term relationships expected from our clients.
Contact Information:
Stephen R Gould: (646) 688-7520
sgould@vcmpartners.com
http://www,rederivs.com
30

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REAL ESTATE DERIVATIVES

Real Estate Derivatives

NYU Schack Institute of Real Estate

3. Review of property indices

1. Review of property indices

Index return% = Value at end of period ÷ Value at beginning of period - 1

There are particular problems with real estate

Still, this is simply a conspicuous demonstration of my Index Theorem:

All other indices are modelled or import assumptions

1. Review of property indices—index types

Repeat sales methods—which are by definition transaction-based—look at the return on indi-

(For those of you so minded, google “hedonic regression”.)

1. Review of property indices—index providers (commercial)

INDEX PROVIDERS - Commercial

1. Review of property indices—index providers (residential)

INDEX PROVIDERS - Residential

Futures and options on S&P/Case-Shiller are traded on CME

Radar Logic (RPX)

2. Review of derivative products

► Agreed-upon notional amount:

► Forward transaction is cash-settled on settlement date

► $25,000,000 forward from 6/1/10 to 12/31/11

On 2/24/12, the index release (for end-Dec 11) is 185.

Payment: (185/175 – 1) x $25,000,000 = $1,428,571 to buyer of forward.

Futures are not fundamentally different from forwards. Major distinctions

2. Review of derivative products

Options on RE indices, like forwards, are cash-settled.

► If index is below 220 in 6 months, option is worthless

Index finishes at:

2. Review of derivative products —Options

2. Review of derivative products

TOTAL RETURN SWAPS

2. Review of derivative products

On 1/25/11, NCREIF reports an annual return for 2009 of 2.5%

► Owner A is due to pay investor B that 2.5% on $25,000,000 = $625,000

Negative swap rates

E.g., 2-year NPI vs. -10%

2. Review of derivative products

Forwards, futures and swaps

Theory only works if

None of these are true for real estate.

2. Review of derivative products

S&P/Case-Shiller futures and options

IPD futures and options—UK, France and Germany

Traded on ISE (Eurex subsidiary)

3. Use of derivative products by end-users

3. Use of derivative products by end-users

Buying protective puts

► No easy way to hedge downside exposure in the cash market

However, note Caveat at end of section.

Total return swaps

After the maturity of swap, exposure returns

3. Use of derivative products by end-users

An amortizing swap can be used against a projected liquidation schedule.

3. Use of derivative products by end-users

Derivatives permit immediate exposure.

► Buying forwards and swaps

3. Use of derivative products by end-users

Lenders and bond-holders

3. Use of derivative products by end-users

3. Use of derivative products by end-users

Problem: investor wishes to reduce exposure in RE rapidly

Problem: investor likes market, to the extent that he is considering leveraging