A real estate derivative is a financial instrument whose value is based on the price of

real estate Real estate is property consisting of land and the buildings on it, along with its natural resources such as crops, minerals or water; immovable property of this nature; an interest vested in this (also) an item of real property, (more general ...

. The core uses for real estate derivatives are: hedging positions, pre-investing assets and re-allocating a

portfolio Portfolio may refer to: Objects * Portfolio (briefcase), a type of briefcase Collections * Portfolio (finance), a collection of assets held by an institution or a private individual * Artist's portfolio, a sample of an artist's work or a c ...

. The major products within real estate derivatives are: swaps,

futures contract In finance, a futures contract (sometimes called a futures) is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset ...

s, options (calls and puts) and

structured product A structured product, also known as a market-linked investment, is a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, and ...

s. Each of these products can use a different real estate index. Further, each property type and region can be used as a reference point for any real estate derivative.

Applications

Swap

The most basic form of real estate derivative is a swap transaction, in which one investor, or one side, goes

long Long may refer to: Measurement * Long, characteristic of something of great duration * Long, characteristic of something of great length * Longitude (abbreviation: long.), a geographic coordinate * Longa (music), note value in early music mens ...

and the other side goes

short (finance) In finance, being short in an asset means investing in such a way that the investor will profit if the value of the asset falls. This is the opposite of a more conventional " long" position, where the investor will profit if the value of ...

. An investor would want to execute a swap if they thought that the market, or sector, was likely to appreciate, in which case they would go long. Alternatively, if an investor’s view was that the market would depreciate from that point, they would go short, or take the other side of that trade.

Options

One can apply options to real estate. A real estate Option is a contract based on a

time horizon Time is the continued sequence of existence and events that occurs in an apparently irreversible succession from the past, through the present, into the future. It is a component quantity of various measurements used to sequence events, to co ...

and an expected

property value Real estate appraisal, property valuation or land valuation is the process of developing an opinion of value for real property (usually market value). Real estate transactions often require appraisals because they occur infrequently and every prop ...

. It is developed based on financial options contracts and adopted to individual real estate assets.

Call

With the real estate call option, the property owner can sell an option in exchange for debt-free cash today. Investor, who buys the real estate call option benefits from property price appreciation and price volatility.

Put

With the real estate put option (selling price decline insurance), the investor can sell an option thus the investor underwrites price decline insurance. The property owner, who buys the option, is protected against price decline of the property.

Derivative efficiencies

Owning real estate assets is costly, and the transaction costs associated with purchasing commercial real estate can be prohibitive. Typical transaction costs can equal 500 - 800

basis point A basis point (often abbreviated as bp, often pronounced as "bip" or "beep") is one hundredth of 1 percentage point. The related term '' permyriad'' means one hundredth of 1 percent. Changes of interest rates are often stated in basis points. If ...

s per transaction. Industry estimates suggest that transaction costs for commercial real estate easily surpass $10–$12 billion annually. Since the US real estate derivative market is new, the transaction costs are at this point variable. However, based on derivatives in other markets, it is anticipated that the costs will be well below the 500-800 basis points required to invest in actual real estate.

Market growth

The market for real estate derivatives was long overdue. Real Estate is the only major

asset class In finance, an asset class is a group of financial instruments that have similar financial characteristics and behave similarly in the marketplace. We can often break these instruments into those having to do with real assets and those havin ...

that only recently developed a

derivatives market The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets In financial accounting, an asset is any resource owned or controlled by a ...

. According to the Pension Real Estate Association’s Plan Sponsor Research Report, pension funds allocate approximately 6.0% of their assets to real estate, making it one of the largest investable

asset classes In finance, an asset class is a group of financial instruments that have similar financial characteristics and behave similarly in the marketplace. We can often break these instruments into those having to do with real assets and those having ...

, after equities and fixed income. Because of the significant transactions costs involved with investing in real estate, derivatives can, but also might not, improve the efficiency of the market.

United States

The market for US real estate derivatives, while in a nascent stage, made significant progress in 2007. There are now a diverse set of indices and methodologies being used to create and structure

derivatives, for both residential and commercial real estate.

United Kingdom

In the UK, the market for property derivatives did not begin until 2004. However, since the market’s inception, the growth has been significant. Through the third quarter of 2007, trades with an outstanding notional value of 7.9 billion pounds have been executed. The U.S. market is still emerging, and has been limited somewhat over the last year by the global credit crunch and uncertain values of

mortgage-backed securities A mortgage-backed security (MBS) is a type of asset-backed security (an 'instrument') which is secured by a mortgage or collection of mortgages. The mortgages are aggregated and sold to a group of individuals (a government agency or investment ba ...

. However, the market in the U.S. is now emerging quickly, with over $500 million worth of transactions to date in 2007.

Australia

Taking the AUD 139.5 billion in Australian residential and commercial property sales recorded in 2006, and applying a 1-to-1 derivatives-to-underlying ratio, the potential PD market would be larger than the $89 billion Australian credit derivatives market. A 2-to-1 ratio would make it more active than the $215 billion interest rate options sector, and a 3-to-1 ratio would put it within reach of the $472 billion ASX options industry. RP Data-Rismark indices is regarded as the market leader of Australia's Property Derivatives Market.

References

{{Real estate Derivatives (finance) Real estate investing