Property Derivatives (Real Estate Derivatives)
A property derivative is underwritten by an underlying real estate asset.
Individual real estate assets are illiquid and hard to price accurately because they sell infrequently. Because of this, it’s common for property derivatives to be based on property indexes.
Real estate property indexes take into account aggregate information on prices within a certain city or multiple cities.
This, in turn, works to provide some type of proxy for the performance of the underlying real estate asset.
For example, if one has a home in New York City, a futures index on NYC real estate might be used to assess the approximate performance of the individual asset.
Some also call participating in the real estate derivatives market synthetic real estate.
Types of property derivatives
Property derivatives are often in the form of futures, forward, total return swap, or part of a fixed income security or note.
When taking the format of a total return swap or forward contract, the parties will usually take opposite positions on the price movements of a broad-scale property index, such as one that’s based on national prices or a city-based index, whichever is most appropriate.
Commercial property derivatives in the US are commonly based on the NPI index, which is put forward by the National Council of Real Estate Investment Fiduciaries (NCREIF).
Residential real estate indices in the US include the S&P/Case-Shiller Home Price Indices (also known as, simply, the Case-Shiller index), Radar Logic’s RPX, CUS (Globex product), and DJUSRE (Dow Jones US Real Estate Index) on ECBOT.
Property indices put out by the Investment Property Databank (IPD) are the only ones used for writing property derivative contracts in the United Kingdom.
The IPD Annual Index covers over 10,000 UK property investments.
IPD indices have also been used in Japan, Australia, and other European countries (e.g., Germany, France, Switzerland, and Italy).
They’ve also been used as the foundation for derivatives on commercial properties.
Property derivatives provide the investor with the ability to:
- Hedge a current position in the physical assets
- Gain or reduce exposure to the property market (i.e., a form of speculation)
- Change the composition of a real estate portfolio more quickly than what’s possible using the physical market
Synthetic real estate enables real estate investors and traders to participate in the market without having to buy the physical assets.
Property derivative creation
To create a real estate or property derivative, there needs to be some type of reference point for the market against which the derivative contracts are priced.
The reference index for property derivatives can be provided by, for example, the IPD in the UK or NCREIF and S&P/Case-Shiller in the US.
The IPD Index Property Index has various indexes and sub-indexes that reflect different parts of the commercial property market. The UK has generally been the most popular market for real estate derivatives.
Types of property derivatives
There are three main types of property derivative in use in the UK property market:
- Property Index Notes(PINs)
- Total Return Swap (TRS), and
- Forwards (which incorporates the IPD Property Index Futures listed on Eurex).
In the United States, property derivative trading is primarily through forwards and futures contracts.
Forwards agreements are made generally on the RPX and NCREIF indices. Futures trading is done by the CME Group via Globex utilizing the S&P/Case-Shiller Home Price Indices.
Total return swaps
A real estate total return swap is an exchange of cash flows.
In this case, the total return on real estate, as measured by the change in the relevant property index (which can be residential, commercial, or otherwise), is based on how much cash needs to be exchanged comparing the current price of the index relative to the initial strike price (much like how an option is settled at expiry).
Pricing on total return swaps may either be quoted as:
- a fixed percentage, or
- a reference benchmark (e.g., SOFR) plus or minus a spread
If you’re buying a swap with a fixed percentage, you will pay that to the counterparty (e.g., five percent, typically quoted as a negative number) and you’ll receive the performance of the real estate index. So it has the payoff very similar to being long a call or put option.
If you pay it out, you’ll receive the fixed percentage amount and you’ll pay out the performance of the property index being referenced.
Property index notes (PINS)
Property index notes (PINS) are equivalent to a form of real estate bonds. They are cash settled debt securities that reference the performance of an underlying property or real estate index.
The issuer will make coupon payments to holders of these assets, with the principal being repaid at maturity, based on the performance of the property index referenced (either capital appreciation or depreciation).
The coupon rate is usually fixed; it can, however, also be a floating rate linked to a benchmark like LIBOR (phased out) or SOFR.
PINS are similar to bonds given they:
- Have a stated maturity date
- Carry a rate of interest that is either fixed or floating
- Are tradeable in the secondary market
PINS however differ from bonds given that they represent an unsecured and unsubordinated debt obligation. This means they rank lower in capital priority if the company were to go defunct.
The seller of the PIN pays the total capital appreciation associated with a property index, plus coupon payments. This is made to emulate the returns associated with holding physical real estate and the cash flows of these bonds are structured in a way that is meant to be quite similar to a transaction in the underlying physical property.
Along with the principal paid on redemption, the coupons paid to investors are typically made monthly or quarterly (more common).
Forwards and futures
A real estate forward or futures contract is based upon the returns of the underlying real estate in any given period.
The expected total return is agreed to at the start of the trade. This is modeled by the forward curve, much like other markets where traders and investors can see the forward path for interest rates, the price of oil, and other assets.
Upon maturity, the difference between the traded price and the realized total return is exchanged between parties.
Forward agreements are over the counter (OTC), which means you can’t rely on an exchange to facilitate the transaction. A counterparty has to be found, which could be a bank, investor, hedge fund, or another entity.
The risk of default of either entity must be considered as part of the trade.
On the futures side, trading is done electronically. The CME Group has been involved in this market since 2006 and represents the counterparty on each trade.
Eurex also has property index futures and serves as a global derivatives exchange.
The most popular contract is based on the IPD UK Annual All Property Index Total Returns, which was introduced back in 2009.
Can an individual or retail trader take advantage of property derivatives?
There are housing index futures that are available in the US. There are nation-wide indexes (such as CUS or DJUSRE) and various city-based ones:
(Source: Interactive Brokers)
However, none of these have options and the indexes themselves are somewhat illiquid.
But if you own a house in one of these cities (or in the US, in general), if you wanted to hedge out some of your price risk, there’s the potential to take a short position in one of the indexes to lower your net exposure to home prices.
A landlord could potentially do something like this to lower their net price risk to the sector.
However, the risk is that the housing index could go up, netting mark-to-market losses. Ideally these losses would simply equal gains in the physical product, but that’s no guarantee.
Real estate is a highly localized and idiosyncratic market.
Real estate options
There are options on housing stocks and real estate ETFs.
The most popular real estate ETF is XLRE, which has options.
However, it’s only an approximate hedge, as it relates to REITs.
If one owned real estate, one could sell OTM call options on real estate proxy stocks to derive premium from their physical holdings.
If the real estate appreciate in value that should, theoretically, mean gains in physical real estate.
But there’s always the risk that they diverge and the physical holdings lag the gains in the financial assets and you lose money.
And even if it was a perfect correlation, shorting calls means you don’t participate in any upside above the strike. Your call premium may not compensate for the gains foregone.