Real Estate Derivatives / Synthetic Real Estate

RE01
Lecture 16:
Real Estate Derivatives

Prof Thies Lindenthal
htl24@cam.ac.uk

March 2023

## US markets lagged behind Torous (2017)

* First CRE derivatives traded in 2005
			- Based on NCREIF index
			- No critical mass in trades, derivatives terminated
		* Chicago Mercantile Exchange tried in 2007, failed too.
			- Underlying index discontinued

Notes:

* Why was UK property derivatives market more successful?
		* UK commercial real estate market is less geographically fragmented which contributes to more effective hedging and less basis risk.
			- How does one hedge industrial warehouse risk in Dallas TX?
		* Widespread acceptance of a single index (IPD) that covers a majority of UK property market.
		- Not the case in US.
	 	* UK property funds (end users) played a significant role in development of UK property derivatives market:
			- Drove regulatory and accounting changes;
			- Their demand for property derivatives has been a key driver of market’s development.
			- By contrast, portfolio managers and pension funds in US did not actively seek out derivative products. More education?
		* Property transaction costs higher in UK making property derivatives more attractive.

## Index families 3 major types of indices
		<img src="imgs/table1.png" height=450>
		Note:

We have three major types of indices at our disposal:
		Indices based on appraisals, transactions, 	and the stock market.

The data source for appraisal based indices are
		appraisals of individual properties
		that are usually self reported by investment managers
		and that then aggregated to estimate a general trend in the market.

Prominent examples for appraisal based indices are the NCREIF index that
		tracks prime commercial real estate in North America, or the famous
		MSCI/IPD index family.

For transaction based indices, we look into
		actual transaction prices of traded properties in private asset markets.
		The challenge there is that we need to control for an apples versus oranges problem,
		since all these properties are unique and we have to account for
		their differences when estimating a market trend.

Two main approaches to control for these non homogeneous goods exist:
		 a repeat sales technique and the so-called hedonic estimation
		 technique. We will have a closer look at these two in the second part of this this talk.

Examples for transaction based indices include:
		the Moody's RCA commercial property price index or the CoStar indices.
		Zillows price estimates for residential real estate are also based on housing transactions.

Finally, stock market based indices tap into the
		 information produced by financial markets: They track the returns
		 to real estate investment trusts, so-called REITs.
		 The ultimate source of REIT returns are the assets they invest in,
		 so one could argue that REIT returns should be correlated with asset returns.
		 Again, more on that later.
		Good examples of stock markets based indices are the NAREIT or EPRA property index families.

## Pro/con – by index type –
		<img src="imgs/table2.png" height=450>

Note:

Let's have a quick look into the strenghts and weaknesses of each
		index type.

The core strength of the appraisal method is that it can be
		applied when other methods are simply not feasible.
		So in cases where you do not have any transactions and where you
		cannot use the stock markets, you can always come up with
		a number of appraisals in &ndashl let's say every quarter –
		and then you use those appraisals to create a price index.

Also in many countries there is a strong tradition
		and a strong professional code on how to do appraisals.
		So this could actually be very reliable.

The big weakness of appraisal-based indices is that they are
		based on opinions, not prices, and they might miss the
		true trends in the market.

Also, they tend to produce very smooth returns and sketch an
		unrealistic picture of the riskiness of real estate,
		and we'll look into that more thoroughly later.

Finally, appraisal based indices might be subject to
		influence by, for instance, the asset owners,
		who ultimately pay for the appraisal.
		They might nudge the appraisers into a certain direction and
		the valuations that the appraiser comes up with are not
		necessarily always reflecting the economic reality.

The big advantage of transaction based indices is that
		they are reflecting actual prices that have been determined
		in the market.
		The reflect the equilibrium of supply and demand and not
		the opinions of appraisers.
		So one could say they are closer to the economic reality and
		should be objective because that's what people have paid for assets.
		There isn't much room for manipulation because in the end
		somebody has to pay the reported sales price.

The biggest disadvantage of transaction based indices is that they
		require large databases of historical transactions.
		We don't always have these – actually, in most cases we have
		fewer data than we wish for.
		Thin data often leads to uncertain and noisy index estimates.

Also, they rely on statistical models,
		and while we are actively developing new models,
		these models are still not perfect in each and every case
		and there's the risk that we might be using the wrong model
		for the wrong data. So there is always uncertainty in any estimates
		and there's a model risk if you will.

Depending on the technique that you're using, some of these
		indices might have the not so nice feature of revisions,
		meaning that the estimates for past dates are not "frozen" in time,
		but might be updated as new data enters the sample.

Stock market based indices are great because they are incorporating
		information so quickly. Shares of REITs or listed property companies are traded in many
		countries and indices based on the returns on these shares benefit
		from the efficiency and transparency that the financial markets offer.

They are easy to implement. We don't have to deal with unruly
		property sales data but instead we just track the returns on
		these publicly listed funds. I have uploaded a short video that
		explains how to roll your own REIT index in 5 minutes.

The biggest drawback of stock market based indices is that
		some countries only have very few REITs or even none at all.
		Many have only a short history of REIT trading,
		or not very efficient stock markets to begin with.

Even if there are enough REIT returns to work with, we have to
		account for the fact that these are returns for companies, not assets.
		These companies are usually financially leverages,
		so we are looking at geared returns not the ungeared asset returns.
		We therefore need to reverse the effect of financial leverage and
		"degear" the returns.

Finally, by being listed, REITs are
		subject to noise from the stock market so
		what we're measuring in the end is a combination of
		true returns that come from the assets, gearing, and
		market noise and sentiment.
		So, stock market based indices have this nice feature
		of providing data 24/7, but it's not always clear that these data
		are really only about the underlying assets.

RE01Lecture 16:Real Estate Derivatives

RE01
Lecture 16:
Real Estate Derivatives