Property Derivative Strategies

This department is presently under construction. Upon completion it will begin
to trade in and offer trading strategies for property derivatives.

Virtual Real Estate:

Property-derivative markets are slowly developing
in the United States and Europe.

Over the last few years, and under the noses of most investors, markets in property derivatives have quietly developed in the United States and the UK. Though both of these markets are very new and not fully established, some believe they could offer a revolutionary way to invest in real estate.

A property derivative is a contract that lets investors bet on the future level of a real estate index. Like any other derivative contract, a property derivative is designed to let investors quickly, easily and cheaply gain exposure to an underlying market – in this case either the commercial or the residential real estate market. A functioning property-derivative market, therefore, allows investors to achieve the same economic outcome as selling an actual property, simply by calling a broker and doing a single trade.

Beyond simplicity, a property derivative’s biggest selling point is that it enables investors to go short and bet on a falling market. Given the current sad

state of the U.S. real estate market, this feature is attracting attention. “A lot of high-net-worth investors and family offices are starting to look at this product now,” says Clayton Dillon, a property-derivative broker with Tradition Financial Services in New York.

The biggest and most developed market for a property derivative is the over-the-counter market established by banks operating in the UK. The reason that got it off the ground is the wide acceptance of two indices that form the basis of derivative contracts there: One tracks the changes in housing prices across the country and the other follows changes in commercial property prices.

The property-derivative market in the U.S. can be split into two parts: over-the-counter markets, which means products originated from investment banks, and exchange-traded markets. In May 2006, the Chicago Mercantile Exchange (CME) began listing U.S. house-price futures and options, which are designed to let investors bet on price movements in the S&P/Case-Shiller home price Index. Meanwhile, in the past year or so, a number of investment banks have worked together to create an over-the-counter property-derivative market on a different set of real estate indices from Radar Logic.

Typically, the over-the-counter property-derivative market operates this way: Banks act as intermediaries by writing swap contracts based on a real estate index covering a specific geographic area and type of property (residential or commercial). They sell this exposure to other institutions, or wrap the contract into a product for wealthy investors, which give them synthetic exposure to property prices.

Market-Ready?

In Europe, where most deals have been done, the buyers tend to be professional investors or other banks,

who then take the property exposure they have purchased and sell it on to high-net-worth and retail investors.

Unfortunately, investment banks are experiencing problems along the path to fully realized property-derivative markets. Property swaps are difficult to price, and because the market has a tendency to be largely one-sided, with most people looking to bet on a move in the same direction, it is difficult for banks to balance their trading books.

The over-the-counter market therefore, especially in the U.S., has failed to become liquid enough to sustain a market in any real sense, which means structured notes linked to U.S. housing prices have yet to materialize.

Meanwhile, at the CME, development has suffered from a lack of commitment to the Case-Shiller index. The CME says that only about 20 to 40 contracts per day are trading. Property-derivative dealers from outside the exchange say there is no real incentive for a market maker to give liquidity in the future contracts – although the CME insists that liquidity is potentially there.

U.S. Property-Derivative indices:

The Chicago Mercantile Exchange’s house-price futures and options are based on the S&P/Case-Shiller indices, which cover moves in residential housing prices across 10 cities: Boston, Chicago, Miami, New York, Denver, San Diego, Las Vegas, San Francisco, Los Angeles, and Washington. These indices are designed to track resales of single-family homes.

The Radar Logic index’s (RPX) range is designed to track house-price movements across 25 U.S. metropolitan areas. Here the aggregate index is calculated on a price-per-square-foot basis, rather than just the overall sale price, and it includes resales, foreclosures, condominiums and new-home deals.

Strategy By John Ferry, Worth, Aug./Sept. 2008