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Transaction Price Indexes and Derivatives a Revolution in the Real-Estate Investment Industry?

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Transaction Price Indexes and Derivatives a Revolution in the Real-Estate Investment Industry? Features Transaction Price Indexes and Derivatives A Revolution in the Real-Estate Investment Industry? David Geltner* Abstract: This article is about two interesting new innovations in the world of real-estate investment that are still flying largely below the radar screen in the U.S., but which I believe have the potential to converge here in this country and revolutionize the industry, and with it, perhaps, even the way many commercial buildings are designed, built and managed. The two innovations are transaction-price-based indexes for tracking commercial-property price movements, and real-estate equity derivatives that allow synthetic trading of investment real estate. Transaction-Price-Based Indexes for Real Estate includes staggered, typically annual, reappraisals of Every major investment asset class needs indexes properties in an index that reports quarterly returns. that accurately track the movements in its market value. The NPI’s relatively narrow property population Stock and bond market indexes of periodic price changes means that it could miss differences between NCREIF abound, and are widely used to study historical risk and member property performance and the broader U.S. return behavior, to understand relative valuations, to commercial-property market. And its appraisal basis help traders predict where they think prices are headed, means that the NPI tends to lag and smooth out to serve as benchmarks or targets for mutual funds and property-market price movements. For example, if the Exchange Traded Funds (ETFs), and even to serve as property market takes a sudden or sharp downturn, the bases for derivatives such as futures contracts that allow NPI may not register such a change for several quarters, synthetic investment in the asset class. or may show only a dampened version of the price drop. Institutional investment real estate in the U.S. has Both of these problems can be mitigated to a for over two decades also had a major index that tracks significant degree by the use of transaction-price-based not only asset-price movements but income and total indexes. Such indexes can be constructed using returns, in the form of the NCREIF Property Index sophisticated econometric techniques developed and (NPI —published by the National Council of Real Estate honed in the academic community over the past few Investment Fiduciaries). The NPI is an excellent index decades. And thanks to the digital revolution of the past for key purposes, such as serving as a benchmark for the decade, transaction-based indexes can be based on a performance of the major institutional investment very broad scope of the U.S. commercial-property managers who are members of NCREIF. It also does an population, not limited to holdings by large institutions. indispensable job tracking the long and intermediate term total investment performance of institutional The NCREIF-based Transaction Index (TBI) property, and helping to provide much of the kind of The first regularly published transaction-based index historical risk and return information about real estate (TBI) of U.S. commercial property was developed by the that the investment industry needs. MIT Center for Real Estate (MIT/CRE) in cooperation with NCREIF, and has been updated quarterly since But the NPI has two major characteristics making it 1 difficult for it to carry the burden of being the only index February 2006 on the MIT/CRE web site. Like the NPI, of commercial property performance. One is that it the TBI is based only on NCREIF properties, but it is directly tracks the performance only of the properties based on the transaction sale prices of the properties sold held by NCREIF members, which represent currently from the NPI rather than on the reported appraised about 5,000 properties amounting to somewhere values of all properties that underlie the NPI. Chart 5-1 between approximately 5% and 10% of the total on the next page shows what the cumulative quarterly price growth of the TBI looks like compared to the NPI, commercial-property investible universe by value in the 2 U.S. The other is that the NPI is appraisal-based and from1984 through the third quarter of 2006. This * George Macomber Professor of Real Estate Finance, MIT Department of Urban Studies & Planning, and Director, MIT Center for Real Estate. 1 http://web.mit.edu/cre/research/credl/tbi.html 2 TBI returns are preliminary until the end of each calendar year. Thus, finalized 2006 quarterly returns will be published with the fourth-quarter returns, in early February 2007. RESEARCH REVIEW, VOL. 14, NO. 1, 2007 16 Features comparison essentially shows the Chart 5-1 pure effect of basing an index on Transaction-Based Index & NCREIF Property Index Since 1984: transaction prices rather than Cumulative Quarterly Capital Return (Price Level 1984Q1=1.0) 2.2 appraised values, holding constant the property population tracked by Price Growth: the index. Note that the TBI has 2.0 TBI: 3.2%/qtr more volatility than the NPI and NPI: 3.0%/qtr Volatility: tends to lead the NPI in time. 1.8 The TBI is published not only TBI: 3.7%/qtr NPI: 1.7%/qtr for the aggregate of all NCREIF sold properties as depicted in Chart 5-1, 1.6 but since 1994 also for each of the four major property types: 1.4 apartments, industrial, office and retail. And the TBI is published not only for price changes (capital 1.2 returns) as depicted in Chart 5-1, but TBI for investment total returns including 1.0 NPI property level income. The latter reveals that retail property has been 0.8 among the strongest investment 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 performers in NCREIF. As shown in Chart 5-2, since 1994 retail Sources: NCREIF & MIT/CRE properties have averaged total returns of 15.3% per year, versus an Chart 5-2 Retail vs OtherChart Property 4-2 Types: average of 14.6% for the other Retail vs Other Property Types: 3 Cumulative Total Return since 1994 property types. Cumulative(value of $1 Totalreinvested Return since since 1994Q1) 1994 7.0 (value of $1 reinvested since 1994Q1) The RCA-based Indexes In December 2006, publication 6.0 and monthly updating of a new Retail: 15.3%/yr commercial-property price index Others Avg 14.6%/yr commenced, based on the Real 5.0 Capital Analytics Inc. (RCA) database of commercial-property 4.0 sales prices. The RCA-based index includes an initial suite of 29 “realized price” indexes designed to 3.0 support derivatives trading. The index construction methodology was 2.0 developed by the MIT Center for Retail Real Estate with the cooperation of 1.0 RCA and a consortium headed by Avg Others Non-Retail Real Estate Analytics LLC (REAL), which is developing the derivatives 0.0 trading platform. The RCA-based 1994 1996 1998 2000 2002 2004 2006 Sources: Transaction Based Index on NCREIF Sales & (MIT/CRE) 3 This is based on an equal-weighted average of the other three property types. At the disaggregate level, apartment properties just barely lead retail properties, with 15.4%/yr to retail’s 15.3%. RESEARCH REVIEW, VOL. 14, NO. 1, 2007 17 Features Chart 5-3 indexes are based on the “repeat- Real Capital Analytics vs Transactional-Based Index vs NCREIF Property Index sales” methodology that is also Aggregate Commercial Property Price Appreciation Since 2000 employed by the S&P/Case- 1.8 Shiller housing price indexes that underlie the housing futures 1.7 contract launched last spring by RCA: 68% 1.6 TBI: 70% the Chicago Mercantile Exchange. NPI: 52% The RCA-based index features a 1.5 monthly-frequency aggregate index, as well as property-sector 1.4 and geographic-region-specific quarterly and annual indexes (the 1.3 latter in four versions, one based in each quarter of the year). The 1.2 RCA database attempts to track all RCA 1.1 commercial-property sales in the TBI U.S. over $2.5 million and includes very extensive coverage 1.0 NPI of this population which measures 0.9 in the several hundreds of 2000 2001 2002 2003 2004 2005 thousands of properties 4 nationwide. Source: RCA-based Repeat-Sales Index Chart 5-3 depicts the cumulative price level of the monthly all- Chart 5-4 property RCA-based index since Retail vs Other Property Types: Price Appreciation Since 2000 its inception in 2001, along with 1.9 the corresponding index levels for the TBI and the NPI (all set to 1.8 equal 1.0 at the end of 2000). Note Retail: 84% that all three indexes depict the 1.7 Others Avg 68% historical bull market in U.S. 1.6 commercial property during 2003- 1.5 2005, with the RCA tending to lead the TBI. 1.4 The RCA-based suite of indexes 1.3 includes quarterly retail indexes at the national level and for a multi- 1.2 Retail state “Western Region” defined 1.1 by NCREIF, as well for the Avg Others “primary markets” defined by a Non-Retail 1.0 national aggregate of the top 10 0.9 metro areas by RCA trading 2000Q4 2001Q4 2002Q4 2003Q4 2004Q4 2005Q4 volume. It also includes annual retail indexes for the (NCREIF) Source: RCA-based Repeat-Sales Index 4 The RCA-based index is currently published simultaneously on the MIT/CRE, RCA, and REAL web sites. The MIT/CRE site includes a downloadable white paper describing the index methodology. The RCA website includes a downloadable white paper describing the data source for the index. RESEARCH REVIEW, VOL. 14, NO. 1, 2007 18 Features East and South regions and for a Southern California $100 million notional value of the RCA swaps, which combination of the Los Angeles and San Diego metro requires no cash outlay up front, as it is a futures areas.
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