Real Estate Derivatives | Property Derivatives


Real Estate Swaps | Real Estate Forwards

A swap is a contractual agreement in which one party will exchange the returns on a particular item for the returns of a different item from another party, the counterparty, for a specific time. In property derivatives, the real estate swap generally comprises of the property returns of an index exchanged for a fixed rate (See Figure 1 below). The property returns are floating rates. Early on, a property index was trade against the prevailing fixed rate measure such as LIBOR or 10 year Treasuries. Investors went long a position by "purchasing" the floating rate in exchange for paying a fixed rate, or they may go short by "selling" the floating rate in return for the fixed rate. An investor who feels the market will improve generally takes a long position. A short position is an investor who believes the market will underperform relative to the index. Payments at the beginning of the contract are set up so that the payment to each party nets to zero. In addition, the total value of the swap (the notional amount) is not exchanged. Only the variations from the real estate swaps fixed index rate require that funds exchange at predetermined time intervals.


Figure 1, Real estate swap agreement diagram.
Diagram of a real estate swap agreement.

Generally, the fixed rate payments were made quarterly at the three month LIBOR rate plus a spread. The floating rate payments were made annually based upon the percentage change in the property index chosen, generally the total property return index. Banks and brokerage houses would act as intermediaries matching counterparties to facilitate deals. Standard agreements were entered by both sides as to the terms of the deal.

Since 2008, the deal model has been simplified. The agreement has been modified to a forward contract. Banks and brokerage houses are acting as market makers allowing deals to execute quicker and reduce counterparty risk. The market pricing of the real estate forwards is based on the expected percentage change in the index over the contract period and set by the market. Contracts are settled annually for both parties. Furthermore, a contract can be exited (unwound) at any time prior to the expiration date. There are still two legs of the swap. The fixed leg is the percentage rate quoted, while the floating leg is the percentage change in the index from one year to the next. Contract maturities are yearly from one to five years. Table 1 below illustrates how real estate forwards are quoted in the market:


Table 1 - NCREIF Total Return Swap Closing Levels
Index Start Date End Date Fix Rate (%)
NCREIF NATIONAL 1Y Dec-08 Dec-09 -17.5266
NCREIF NATIONAL 2Y Dec-08 Dec-10 -9.8555
NCREIF NATIONAL 3Y Dec-08 Dec-11 -7
NCREIF NATIONAL 4Y Dec-08 Dec-12 -5
NCREIF NATIONAL 5Y Dec-08 Dec-13 -3

To illustrate how real estate forwards may work, let us suppose we are looking to go long (pay a fixed rate to receive the floating rate) a three year contract which has a fixed mid rate of (-7) percent. The notional amount we are purchasing is $10 million. Therefore, we can calculate a fixed payment:

$10,000,000× (-0.07) = (-$700,000)

The contract is netted out to zero payment; so although we are to receive a payment, we are required to make a payment of the same amount (See equation below). No principal is exchanged on the $10 million notional amount, but margin requirements need to be deposited.

Fixed Payment = -(Floating Payment)

Let us assume that our long position in the real estate forward performs as follows (See Table 2):


Table 2, 3YR Index Returns - Long Position
Year NCREIF Fixed Rate Fixed Payment Floating Payment Amount Due
Dec 2009 -7% -7% $700,000 -$700,000 $0
Dec 2010 -10% -7% $700,000 -$1,000,000 -$300,000
Dec 2011 +3% -7% $700,000 -$300,000 $400,000

The Amount Due is the amount that is either paid or received each year due to the yearly movement of the index in relation to the fixed rate. In the first year the change in the index matched the fixed rate, therefore, no payment is due to either party. In the second year (Dec 2010), the index was down from Dec 2009 by 10% that is 3% lower than the fixed payment. The investor who was long (receiving the index) would have to pay $300,000. Year three (Dec 2011) showed a positive gain in the index from Dec 2010 of 3%, therefore, the investor going long the index would receive a payment of $400,000.

If we had gone short on the three year real estate forward, our scenario would have looked as follows (See Table 3):


Table 3, 3YR Index Returns - Short Position
Year NCREIF Fixed Rate Fixed Payment Floating Payment Amount Due
Dec 2009 -7% -7% -$700,000 $700,000 $0
Dec 2010 -10% -7% -$700,000 $1,000,000 $300,000
Dec 2011 +3% -7% -$700,000 $300,000 -$400,000

To summarize, the investor going long (buying the index) is expecting improving market conditions. The investor going short (selling the index for a fixed payment) is expecting deteriorating market conditions. Annually, the amount due each party is calculated based on that years change in the index. Both payments are netted out so only the amount due is based on the variance of the index change vs. the fixed rate.?

These agreements allow investors to take on real estate risk through the index without having to deal with actual bricks and mortar - synthetic real estate. Investors are dealing with relative values of real estate measured by an index not with specific building and site issues. With indices covering various property types, trades have been done for specific property types such as residential, retail, and office. Within the residential indices, there are even specific cities (MSA's) and regions that trade. By trading real estate risk, a broad range of strategies can be deployed by the well-informed investor.

Unfortunately, the real estate forward agreements have a major drawback for the small investor. They were primarily set up with large investors and institutions in mind. The average contract (notional) amount is around $5 million. Hundreds of thousands of dollars are required to set up agreements with the banks or brokers to conduct trading. You need to deposit 10-20% cash as collateral as well as the ability to cover and guarantee the entire contract value. Trading is done over the counter either through a broker or with a financial institution. They are out of reach for most small investors.

Where the real estate forwards are valuable to us is they give us a window into what those in the market feel about the future, implied returns. Although we understand that it is impossible to predict what will happen in the future, the implied returns show the current future expectations of the market. Radar Logic publishes the implied home price appreciations on their website for the PRX index. Each month they update the implied home price appreciation (HPA) from the time of publication to the expiration of each contract. As the contract gets closer to expiration, the implied HPA will eventually converge to the closing price. Far from being perfect, the implied HPA is generally good at predicting the market's direction. It provides a good metric to measure our predictions and expectations.


Real Estate Futures

Futures are legally binding agreements between parties who each have specific obligations spelled out in the contract. The future agreement and commodity (index in our case) are standardized which allows traders to enter into and exit their positions. Trading is done through an exchange, which helps facilitate trades with market makers and clearinghouses. The main differences between futures and forwards are that futures are marked to market and guaranteed by the exchange or clearinghouse. Marked to market is simply settling the accounts of traders each day based on the closing value of the future. Value gains are credited and loses deducted from the trader account daily. Having the exchange / clearinghouse guarantee the contract reduces counter party risk - the risk the other party will not fulfill their obligations. The contracts are priced based upon an underlying index with all settlements made in cash. No actual real estate is ever exchanged. As the value of the index changes, the future contract's value will also change. Buyers anticipating a future increase in the index values purchase contracts - go long. Traders anticipating a decrease in the future index level sell contracts - go short.

Currently the CME Group, formally the Chicago Board of Trade and Chicago Mercantile Exchange, has real estate future contracts on the S&P / Case Shiller Home Price Indices (CSI). Contracts are available covering ten major metropolitan housing market indices and the ten city composite index. Additionally, contracts on price spreads between indices are also available.


Table 4, Traded Real Estate Future Contracts on CSI
Traded CSI
Boston Chicago Denver Las Vegas Los Angeles
Miami New York San Diego San Francisco Washington, DC

The contract size is determined by multiplying $250 by the real estate future contract's index level. To illustrate, if the real estate future contract was bought at 100, the contract size would be $25,000. The actual value of the index itself is known as the spot price. The minimum index movement allowed is 0.2 that equates to $50 increments for contract value. The contract months for the contract vary depending on the length of the real estate future contract. Contract lengths extend out up to 60 months in length. Contract months vary depending on how far out the expiration date is. Yearly contracts and contracts with no more than 18 months to expiration are listed on a quarterly cycle: February (G), May (K), August (Q), and November (X) - the letter in parenthesis is the month's symbol for the contract symbol. For contracts running nineteen to thirty-six months, the contract months are May (K) and November (X). Over thirty-six to sixty months, the contact month is November (X). All contracts expire on the last Tuesday of their respective month. The last trading day for the contracts is at 2:00 PM the day prior to expiration.

The contract's symbol is composed of the contract, month, and year. For example, the contract CUSG0 is broken down into CUS, G, and 0. CUS stands for the composite index, and G stands for the contract month of February. The zero at the end is the year, which in this case is 2010. Taken together, the symbol CUSG0 represents the Composite Index February 2010 contract.


Table 5, Real Estate Future Contract Symbol Components
MSA Symbol
Boston BOS Miami MIA
Chicago CHI New York NYM
Denver DEN San Diego SDG
Las Vegas LAV San Francisco SFR
Los Angeles LAX Washington, DC WDC
Composite 10 CUS
Contract Month
February G May K
August Q November X

A confusing point for the contracts is due to how the S&P/Case-Shiller indices are published. On the last Tuesday of each month, the indices are published with a two-month lag. For instance, at the end of December the indices are released for data through October. Spot prices for each index are based on lagging data. Cash settlements of contracts at expiration are settled on the day the index is published. A contract expiring in May will be settled on the "just" published index values for March.

Real estate future pricing reflects the market expectations in the future values of the index utilizing arbitrage arguments. Arbitrage is done by a trader utilizing pricing differentials between markets to make a riskless profit. For example, let us pretend that a trader observed that a product selling on two different markets had different prices - market A and B. Market A has the product priced lower. Our trader would take advantage of the situation by buying the lower priced product from Market A then immediately selling the product for a higher price on Market B. In our simple example, the trader has made a riskless profit; arbitrage. In transparent markets, the arbitrage opportunities do not last long. Other traders would take advantage of the price mismatching. Soon due to high demand, the product in Market A would increase in cost, simultaneously; due to the increase of supply, the product would lose value in Market B. Eventually and quickly, the arbitrage opportunity disappears. Our product has reached a new spot price based on the actions of the market - no more free lunch.

How does this apply to real estate futures? Here it gets a bit fuzzy. The S&P/Case-Shiller Home Price Indices are not traded, so there are no arbitrage opportunities between the index and the derivatives. Pricing in property futures is based on arbitrage in expectations. The current price of the future contract implies the current market forecast of the index level at the expiration date. If the underlying index is expected to decrease in value, the price of the future contract may be less than the current index level, discounted. When there is an expectation that the underlying index is going to rise, the price of the futures contract may be higher than the index level, a premium. In concept, markets are supposed to be highly efficient making arbitrage opportunities rare; "no free lunch". If the contract price paid happened to match the contract expiration price there would be no profits gained in contract value - the market had already priced the index movement.

Where profits can be made is when market expectations are off. As the future contract approaches expiration, the contract value converges with the index level. If the index is lower/higher than initially anticipated, traders who bought at the earlier price levels may realize a loss/gain. With property derivatives, there are really no arbitrage opportunities as might be found in currency or equity markets. The best we can do is to attempt to lock in an expected payoff.

Also seen in the chart for the Miami August 2008 (MIAQ08) contract (See Figure 2 below), initially there is a discount from the spot price of the index around ten percent. If you recall, August 2008 was the beginning of the sub-prime mortgage meltdown. The discount implies that the market feels the index should fall by ten percent from the current spot price of 264.89. As new information regarding the condition of housing and new index values are published, we can see that the real estate future price is continually adjusting trying to anticipate the index spot price at the contract expiration. When we get closer to the contract expiration, the real estate future contract price will converge with the index's spot price. For this contract the settlement price and index spot price were 189.8. The value is twenty-eight percent lower than the initial index spot price of 264.89, and twenty-one percent lower than the initial future price of 240.2. It seems the initial market expectations were off by quite a bit. It should be noted that in the period before contract expiration that the future price may not track the index level as seen in the prior chart.


Figure 2, Miami August 2008 real estate future contract value plotted along with the Miami S&P/Case-Shiller Index.
Chart showing how the index value and real estate future contract value become equal at expiration.

The chart for the Miami August 2006 contract is different from the August 2008 (See Figure 3 below). May 2006 was the first year that the property future contracts were trading. The first few months of future pricing were at a substantial premium. Housing prices in those days must have seemed as if they would go up forever. This belief was the prevailing emotion was at the time. If you had jumped in and purchased (went long) the Miami contract you would have lost money, even though the index spot price increased. The initial price drop was due to mispricing of the contracts by the initial market makers. As time passed, we see the future prices begin to track the index level. Still, the loss going long is due to expectations that the index will increase. It comes down to determining if the future contract's price, when you buy, matches your expectations for the index level.


Figure 3, Miami 2006 real estate future contract and index.
Chart showing how the index value and future contract value become equal at expiration.

The real estate future contracts that we have covered are known as outrights. Spreads are also available for trading. A spread is pretty much what the name implies, how far apart values are. The two types of spreads available for property futures are intra-market and inter-market spreads. An inter-market spread is speculating on the price difference between two different MSA contracts with various expiration periods. For example, a spread could be offered between the Boston February 2010 and Chicago November 2010 home price indices. The price of the spread is difference in expected expiration prices of the contracts. Intra-market spreads are also known as calendar spreads. Instead of speculating between different markets, we speculate on the difference in the expiration price of the same contracts in different periods. An example would be a calendar spread between a Boston August 2010 contract and a Boston November 2010 contract. Spreads have some advantages over outrights. First, the performance bond is much lower than an outright contract providing higher leverage for the same trade. Second, the structure of the spread is considered hedged, which is why the exchange requires a smaller bond.

Spreads are puzzlingly simple yet difficult to grasp. When looking for a spread trade we are actually trading two contracts, not one. One trade will always be long (hoping the index rises), while the other will always be short (hoping the index falls). For inter-market (calendar) spreads, the earliest dated contract is known as the front, while the later dated contract is known as the out. In inter-market trading of different home indices of the same date the first listed contract would be the front and the second listed contract would be the out, otherwise the earliest date is the front.

The out contract is considered a hedge for the front contract. If we take a short position in a spread, we are bearish on the front contract. Therefore, the front contract is short (short leg) while the out contract is long (long leg). We are betting the front contract will reduce in value relative to the out contract beyond the spread bid price. Pricing for going short the spread is in the bid column of the CME Group webpage for the real estate futures. With a bullish or long spread position, we go long on the front contract and take a short position on the out contract. Here we expect the front contract to rise in value and the out contract to reduce in value. Again, the difference in value must be greater than the price of the forward spread - the asking price. To unwind a spread we need to acquire offsetting positions for both trades. Even if the long and short trades are profitable themselves, if the spread position costs more than the difference between the long and short legs we have lost money. Profitability is dependent on the spread price.

To illustrate, in March we take a long position on a Boston May/August contract. The May contract is at 100, and the August contract at 95. The current home price index for Boston is 105. The asking price for the long calendar spread is 8.0, which is greater than the price difference between the contracts. The May contract expires with the index and contact valued at 103. We have made a profit of 103-100 = 3 on the front or long leg. Now we need to close out our short leg. Prior to expiration, we can take an opposing position to close the contract, or we could choose to wait until expiration. There could be some margin issues if you continue past the front leg though. For this examples sake we must close our position when the front contract expires - we are able to purchase a long position at 92 that closes out the short position. Again we have made a profit of {95 - 93} two basis points, but for the short leg. Totaling the returns of the legs together, we have made a total return of five basis points. Unfortunately, we paid eight basis points for the deal - we would lose three basis points which equates to (3 x $250) = $ 750. We lost $750 when our individual trades would have made profits.

Trading of the S&P/Case-Shiller Home Value Indices is done electronically through CME Group. Any commodity brokerage firm or on-line futures trading platform with access to the CME Group can trade the real estate futures. Similar to other future contracts, the full amount of the contract is not settled until contract expiration. Only a margin requirement of 20% of the contract amount needs to be deposited into a trading account to take a position. The exchange has maintenance margins for each contract that allows a range of value movement prior to requiring more money to be deposited in the account to hold the position, known as a margin call. Fees for trading are inexpensive compared to physical real estate. Using a broker the total transaction fee for buying and selling (round-trip) a future contract is approximately $27 per contract regardless of the contract size. Electronic trading fees are only around $7 per contract round-trip. The fees amount less than 0.01% of the contract price, which is negligible


Options

Options are contracts between parties that gives the buyer of the option the right to execute an agreed upon action within a defined timeframe for a cost. The main difference between options and futures/forwards is the buyer is not obligated to execute the contract - they have the right to execute for a fixed period.

In real property, real estate options have been in use for ages. Property investors would enter into an option contract with the owner of a site of interest. Typically a small fee is paid to the owner and the investor gains the right to purchase the site for the agreed upon amount within a set period. In these deals, the option contracts may contain similar details, but there are no industry wide standards. Each deal is unique. To sell the option for a profit the investor needs to locate a buyer and negotiate a sale. Executing the option is generally done to gain possession of the site, but some investors are successful at reselling them. Although a useful tool to the experienced real estate investors, they are not liquid enough for part time real estate speculators.

For small speculators an active options exchange is better suited. The Chicago Board Options Exchange is a good example. Utilizing electronic trading and clearing, a small speculator can enter and exit trades almost instantly through any on-line trading platform or broker. Unfortunately, at the time of writing, no property derivative options are available through an exchange. Only over the counter options can be found, but in limited quantity geared toward institutional sized investors. However, due to the utility options bring to the table we should see market trading sometime in the future. Therefore, we will cover some basic concepts and issues to be found in property derivative options.

These days there are many types and styles of options. Property derivative options, however, seem to be limited to "vanilla" options - calls and puts. These options, similar to real estate options, are currently not standardized. However, they would all need to have some basic contract specifications. First is the type of option, a call or a put. Calls give the option holder the right to buy, and a put gives the option holder the right to sell. The next item to be agreed upon would be the quantity and index/future. A strike price is selected where the option holder can exercise the option. Finally, an expiration date and settlement terms are determined to include the current cost of the option. Most options are of two styles, European and American. A European option cannot be exercised until the expiration date - you are in to the end. American options can be exercised at any time during trading up to the expiration date.

How the put and call options work is straight forward. To illustrate, let us assume that a trader is interested in Miami residential property values. Looking at the available Miami future contracts, she calculates that the future prices are too low in a contract that is one year from expiration. Let us assume the Miami housing price index being is at 149, the future contract being considered is selling at 140 - where the market expects the index level to be at expiration. Our trader is expecting a rebound this year, so she checks to see what call options are available. She finds a call option for a forward contract on the index with the same contract period as the underlying future contract she feels is mispriced. The strike price is 150 and it will cost $500. Feeling confident, she purchases the option. Because it is an American style option, she can exercise the option at any time the value of the underlying future contract exceeds the strike price, 150. To make a profit not only does the value of the future need to exceed 150, it needs to be high enough to account for the option cost and brokerage fees - around $520. Because we know the home price indices are priced at $250 times the index, she calculates to make money the future needs to exceed a price of 152.2. Since the index only moves in increments of 0.2, she had to round up.

A few months roll by and Miami is experiencing another boom - who knew? The price of the futures contract is now at 160, and our trader decides to exercise the option. She is able to purchase a forward contract at 150 and then sells it at 160. Her profit on the deal is (160 - 152.2) x $250 = $1,950. If there were an active option market, the value of the option would have increased along with the future. She would have been able to sell the option itself for a profit. Had the value of the future not exceeded 150, the option would expire worthless. If she exercised the option under 152.2, she would realize a loss.

A put option is just the opposite of a call option. A put option allows the option holder to sell a futures contract at the strike price once the price of the future has fallen below the strike price. For example, if the Miami future was at 140 and we felt it was going to drop. We purchase a put option on the future with a strike price of 130 for $500. Including the option price and brokerage fees, $520, the future price needs to drop below 127.8 before we make a profit. The future and option expiration are the same. If the future price falls to 120, we would exercise the put option. We would purchase the underlying future at 120 and sell it at the strike price of 130. Our profit would be (127.8 - 120) x $250 = $1,950. If the value of the underlying future remained above 130, the option would expire worthless. Put options also change in value as the underlying contract value moves. Instead of exercising the put option, we could have just sold it - if there was a market.

Options are also used to hedge risk. Hedging is a way to limit losses for unexpected market movements. Think of it similar to auto insurance. We never expect to get into an accident, but if the unexpected happens we have insurance to help pay for the costs. To illustrate a hedge, suppose we were to purchase a forward futures contract expecting the price to rise. In order to protect our investment if the future price fell significantly, we could purchase a put option on the future. If we are correct in our estimates that the future price went up, we made a profit minus the cost of the option. In the event that the index plummeted along with our contract value, the option would limit our loss to the brokerage fees and difference between the future price and put option strike price. So if we bought a contract at 130 and a put option at a strike price of 120, when the contract expires at 110 our loss is (130 - 120) x $250 + (120 - 110) x $250 = $0. Considering the brokerage fees, we would have lost around $50. Similarly, when taking a short position, betting the market is going down, we can hedge using a call option. If the market goes up instead of down the call option gains would offset our losses in the future short position.

Options on real estate derivatives have some issues. First, there are not many options being offered so finding an option on a particular home index future is problematic. Without a market to trade the options they are over the counter, which literally means you must find someone and deal directly. Second, if an option is located we need to be sure that the price of the option in reasonable - here we run into some technical issues which make the pricing problematic. Current option pricing methodology does not work for options on the index since we cannot replicate the index. Options on the futures contracts can probably be modeled using a binomial model or Black-Scholes for the technically inclined. For the small investor, options on real estate futures may be a bit out of reach presently. Once a market in the property future options is up and running, the options will become a useful investment tool.



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