Wall Street banks losing tens of billions of dollars on soured commercial real estate investment may seem like just one more bit of bad news from the credit related asset bubble and market crash. But therein lays a cautionary tale with a twist.
Most market observers blame “complex derivatives” for the residential real estate price bubble and collapse — far easier, perhaps, to blame a computer model than to blame human factors like fraud, greed and hopelessly out of control leverage.
But in the institutional commercial property sector, precisely the opposite is true. Most institutional investors in commercial real estate are exposed to “physical” real estate projects — actual buildings, many of them over-the-top office and leisure complexes built in anticipation of a continuing credit-driven development boom. But when the global market for residential real estate plunged, the value of these investments went over the cliff with it.
Ironically, institutional investors could have protected their downside with...derivatives. Amid all the Monday morning quarterbacking over leveraged derivative alpha plays gone bad, it’s worth recalling the “defensive” role that derivative instruments play every day in energy, commodity, agricultural and financial markets.
In numerous industries, managers build business plans that use derivatives to smooth out unwieldy price fluctuations for commodities, energy and capital. The same could have held true for these multi-billion-dollar bets on commercial real estate.
Institutional Investors and Real Estate
While the $6 trillion U.S. commercial real estate market has a proven track record of robust valuation growth and a valuable lack of correlation to bond and stock markets, institutional investors have typically held only small allocations to the sector.
While real estate today accounts for in excess of 40 percent of total U.S. capital market investment, most pension funds limit their direct investment in the real estate sector to single digit percentages. Even university endowments known for their aggressive real estate investing tend to limit allocations to around 15 percent of their portfolios.
The reason for this endemic under-weighting has everything to do with the relatively opaque and illiquid nature of real estate investment. The vast majority of real estate transactions are not undertaken on exchanges or even on over-the-counter financial markets. They are, in the main, one-to-one transactions in which both parties have only an imprecise sense of the “right” price. While this process has become more transparent, commercial real estate transactions remain a long and labor intensive process.
This market could be made substantially more liquid and efficient with commercial real estate derivatives. By allowing investors to easily purchase and sell exposures and to leverage their investments in both long and short directions, derivatives would allow institutional investors to manage cash flow when buying or selling properties, gain more rapid access to returns, rebalance portfolios among property types or regions, diversify risks among property types and regions, make directional bets, “harvest alpha” through simultaneously buying buildings and shorting indexes and, most importantly, hedge risks of volatility or price declines.
For two decades, investment banks have tried and failed to create an over-the-counter (OTC) market in commercial real estate derivatives. But by using derivative instruments based on the NCREIF National Property Index, sponsored by the National Council of Real Estate Investment Fiduciaries, or on the Moody’s/REAL Commercial Property Price Index (CPPI), or the IPD suite of indices for non-U.S. exposure, investors could effectively hedge away much of their market beta risk.
Had investors made judicious use of these tools over the past five years, they would have saved themselves and their clients billions of dollars. Perhaps this time around, the high-profile investment losses of sophisticated investment banks and asset managers will make clear the need for the more articulate pricing mechanisms, transactional precision and risk mitigation that a robust derivatives.
Neal Elkin is President of Real Estate Analytics, LLC (REAL), developer of a full suite of transaction-based US commercial real estate price indices called the Moody’s/REAL Commercial Property Price Index
