View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by DSpace@MIT Barriers to Growth in the US Real Estate Derivatives Market By Jani Venter Bachelor of Architecture, 2000 Bachelor of Building Arts, 1998 University of Port Elizabeth Submitted to the Department of Urban Studies and Planning in Partial Fulfillment of the Requirements for the Degree of Master of Science in Real Estate Development at the Massachusetts Institute of Technology September, 2007 ©2007 Jani Venter All rights reserved The author hereby grants MIT permission to reproduce and publicly distribute both paper and electronic copies of this thesis document in whole or in part in any medium now known or hereafter created. Signature of author___________________________________________________ Jani Venter Department of Urban Studies and Planning July 27, 2007 Certified by_________________________________________________________ Gloria Schuck Lecturer, Department of Urban Studies and Planning Thesis Supervisor Accepted by________________________________________________________ David Geltner Chairman, Interdepartmental Degree Program in Real Estate Development Barriers to Growth in the US Real Estate Derivatives Market By Jani Venter Bachelor of Architecture, 2000 Bachelor of Building Arts, 1998 University of Port Elizabeth Submitted to the Department of Urban Studies and Planning in Partial Fulfillment of the Requirements for the Degree of Master of Science in Real Estate Development Abstract Commercial real estate is an important asset class but it does not yet have a well-developed derivatives market in the United States. A derivative is a contract that derives its value from an underlying index or asset. Examples of the most well-known derivatives that have been widely used and traded for years are stock options, commodity futures and interest rate swaps. The advent of direct real estate equity derivative products has created the opportunity for similar applications in both the US and international commercial real estate markets. The United States is currently experiencing a convergence between real estate and finance and it appears that the real estate derivatives market might be ready to take off. The use of derivatives could improve the functioning of the real estate industry by allowing investors to gain or reduce exposure to the commercial real estate asset class without directly buying or selling properties. The increased liquidity and reduced up front capital requirements provide added flexibility in executing real estate investment strategies (i.e. speculating) and managing risk (i.e. hedging). This has resulted in significant interest in the development of commercial property derivatives by key players in all sectors. A number of barriers (e.g., indices, pricing, education, fund mandates, tax and accounting treatment) still exist that hinder the successful implementation and growth of real estate derivatives in the US commercial real estate market. It is crucial for the market to overcome these barriers in order to revolutionize the institutional world and allow investors to gain exposure to the real estate asset class and to hedge private real estate risk. This thesis analyzes these barriers to the development of a synthetic market that is on the brink of expanding. The US real estate sector is an eight trillion dollar market composed of real estate assets which has been managed until recently without pointed focus on the property specific risk. The size of this market presents a vast opportunity for risk hedging, asset allocation and portfolio rebalancing in a more efficient manner through the use of derivatives. Thesis Supervisor: Gloria Schuck Title: Lecturer, Department of Urban Studies and Planning 2 Table of Contents Chapter One: Introduction and Overview ..................................................................... 6 The Question................................................................................................................... 6 The Purpose .................................................................................................................... 8 Chapter Two: Methodology........................................................................................... 11 Chapter Three: Real Estate Derivatives....................................................................... 15 Definition of a Derivative ............................................................................................. 15 Industry definitions ................................................................................................... 15 Other synthetic products........................................................................................... 19 Derivative markets.................................................................................................... 19 Advantages and Disadvantages of Real Estate Derivatives.......................................... 20 Reduced cost, speed and ease of transaction............................................................ 21 Hedging real estate market risk................................................................................ 22 Re-allocation between asset classes ......................................................................... 23 Portfolio rebalancing within sectors ........................................................................ 24 Trading Alpha ........................................................................................................... 26 Chapter Four: History and Development..................................................................... 28 UK real estate derivatives market................................................................................. 28 Current state of the market ....................................................................................... 28 Market development and regulatory issues .............................................................. 30 US real estate derivatives market.................................................................................. 34 Current state of the market ....................................................................................... 34 Market development & motivations for using derivatives ........................................ 34 Correlation between the US & UK markets ................................................................. 35 UK versus US market fundamentals ......................................................................... 35 The slow growth of the US real estate derivatives market ........................................... 40 Market conditions ..................................................................................................... 40 Chapter Five: Derivatives Compared to other Investment Vehicles ......................... 42 Synthetic, direct and indirect investment...................................................................... 42 Direct investment ...................................................................................................... 44 Indirect investment.................................................................................................... 44 Synthetic investment.................................................................................................. 46 Risks associated with investing with real estate derivatives......................................... 47 Parties as risk? ......................................................................................................... 47 Basis risk................................................................................................................... 48 Counterparty risk...................................................................................................... 48 Leverage and company set up................................................................................... 49 Chapter Six: The Market Players ................................................................................. 51 UK real estate derivative market................................................................................... 51 Market participants................................................................................................... 51 3 Motivations for using derivatives.............................................................................. 54 Parties waiting on the sidelines ................................................................................ 55 US real estate derivatives market.................................................................................. 55 Market participants................................................................................................... 55 Parties waiting on the sidelines ................................................................................ 57 Chapter Seven: Barriers to Growth.............................................................................. 59 Indices........................................................................................................................... 61 1. NCREIF NPI ......................................................................................................... 63 2. RCA Based ............................................................................................................ 65 3. S & P/GRA ............................................................................................................ 65 4. REXX....................................................................................................................