The Real Deal New York

Lutnick’s big hedge

With two new firms under his control, Howard Lutnick’s BGC Partners looks to launch property derivatives market — and he is not alone

March 01, 2012
By Adam Pincus

BGC Partners CEO Howard Lutnick

Howard Lutnick’s announcement last month that his firm BGC Partners would buy distressed brokerage Grubb & Ellis through a Chapter 11 bankruptcy moves the conversation from why he’s getting into the commercial real estate game to how big a company he wants to build.

The purchase announcement came four months after the financial brokerage bought real estate services firm Newmark Knight Frank, and just weeks after Lutnick boasted on Bloomberg Television that he hoped to someday capture “25 percent of the [commercial real estate] market share.”

While executives at the three firms are no doubt strategizing behind the scenes on how to combine the companies into one, Lutnick, BGC’s chairman and CEO, has another, more revolutionary scheme in mind: real estate derivatives.

BGC — which spun off from investment bank Cantor Fitzgerald in 2004 and made its name as an intermediary in wholesale financial markets — has been tight-lipped about the details of that plan, one of the most anticipated aspects of BGC’s foray into commercial real estate.

“What you do is you create a Wall Street-type product, but not a big trading index or a futures exchange,” he said earlier this year during the television interview, referring to his alternative type of derivatives market.

(Derivatives are contracts between parties that allow them to hedge or place bets on changes in prices on everything from the price of oil to office asking rents.)

The purchase of the Midtown-based Newmark Knight Frank — which operates in the United States but is a partner with the global, London-based commercial and residential brokerage Knight Frank — closed in October for around $100 million, including $63 million in cash and the rest in stock.

Whatever Lutnick’s goal with Newmark — which is headed by veterans Jeffrey Gural and Barry Gosin — and Grubb, his plan to create a real estate derivatives platform to be used in New York City and nationwide is no doubt a tall task. And, he’s not the only one racing to profit from derivatives. Several of the most prominent indices that could be used for derivative trades are rushing to revamp their systems.

Derivative trading in the U.S. pegged to local and national commercial real estate has failed in the past, and commercial real estate brokers in the trenches remain skeptical about the prospects for it now. But some financial brokers are more confident that these types of derivatives are coming to New York, sooner rather than later.

“With more realistic expectations from Wall Street, I think that [tenants, landlords or investors] will be somewhat more receptive to using derivatives to gain exposure or hedge it,” said Stephen Gould, senior vice president of real estate derivatives at Wall Street brokerage firm Vyapar Capital Market Partners. “And it is that end-user receptivity which will reboot the product.”

Newmark CEO Barry Gosin

Holy grail

Property derivatives are something of a holy grail in the commercial real estate world, promising to protect landlords and tenants from fluctuations in rents. That’s because derivatives have the ability to revolutionize the way tenants and landlords hedge against swings in the market.

While Lutnick declined to be interviewed for this story, he has recently publicly said that derivatives allow a tenant who’s worried about a rent spike when its lease expires a few years out to buy a sort of insurance against that. Conversely, it allows landlords to mitigate their losses if the market erodes.

The market swings can certainly be dramatic: Cushman & Wakefield data, for instance, shows Manhattan average office asking rents rose by nearly 70 percent between 2005 and 2008.

During the boom, many of the top commercial firms like Cushman, Newmark and Staubach Company (which was bought by Jones Lang LaSalle in 2008) were working on data to feed into a derivatives market.

Many in the industry have assumed that any derivative platform to come to the market would be based on a property index such as the one compiled by the Chicago-based National Council of Real Estate Investment Fiduciaries or the REBOR indices, which are published by a company called Rexx Index. Economist Paul Frischer is president of Rexx.

But Lutnick said he would create custom derivatives without using an index, with each trade an individual negotiation. Lutnick has not provided a thorough explanation of how the trades would be made, or if they could be sold on the secondary market, and a spokesperson could not elaborate.

While it’s unclear how Lutnick will construct derivatives without using an index, there are three basic ways these types of financial products can work with one, experts say. One of those indices is pegged to the net incomes generated by the pool of buildings in a property index. The second is similar, but is based on asking rents in a pool of buildings. And, the third is based on changes in property values.

In the rental scenario, a tenant with a lease expiring who wants to protect against a market upswing would negotiate a futures or an options contract. In simple terms, such a contract, negotiated through a brokerage with a counterparty such as a hedge fund, would mature in a set period of time; for example, three years. If the actual rental rate came in above the agreed-upon price when the contract expired, the tenant would receive money from the counterparty, which would help cover costs of the higher rent. Conversely, if the rent came in below the contract price, the tenant would pay the counterparty, although the tenant would also receive a break because its rent would be lower than expected.

Some brokers don’t see this kind of real estate derivatives market working here because a lease transaction is more complicated to hedge against than, say, the price of oil.

Nonetheless, Lutnick’s plan to market derivatives to clients comes just as some commercial real estate analysts are predicting that Manhattan asking rents will spike in the coming years. Cushman researchers wrote in January that they expected Midtown Class A rents to jump by 30 percent in the next three years. That’s just the kind of spike a tenant would want to protect against.

Today, with no commercial real estate derivatives market in the U.S., tenants and landlords have only the old-fashioned ways to hedge against rent fluctuations in large leases — primarily termination and expansion clauses and renewal options. A derivatives market would radically change that by allowing third parties to place bets on commercial leases.

Of course, the first firm to successfully launch a derivative product would have an enormous advantage. That’s why two of the three major U.S. real estate indices that might be used to trade property derivatives are quietly tinkering with their systems.

Derivative doubters

Even as property derivatives were taking off in London in the middle of the last decade, no one could get the needed traction in the U.S. to make a comparable system work here.

BGC got into the action, as did Newmark and virtually all the major commercial firms, by providing data to different derivative indices attempting to get off the ground.

“It was back in the ’07 era. It was the Index Wars,” said Robert White, president of the data research firm Real Capital Analytics, which is in the midst of retooling its own property derivative index. “Everyone was fighting for what index would become dominant.”

Indeed, in 2006, BGC announced a partnership with Cushman to develop a trading platform in Europe. Spokespersons at Cushman and BGC were unable to say last month if the initiative was still active.

Also, in March 2011, just a few weeks before announcing its plans to buy Newmark, BGC trumpeted that it was partnering with a division of Jones Lang LaSalle to provide clients property derivatives capabilities in the United Kingdom. It is also unclear if that initiative remains in place.

For a brief period during the boom, three major indices did gain attention here.

Newmark Chairman Jeffrey Gural

One of them, which was pegged to investment returns of core properties, was developed by the above-mentioned National Council of Real Estate Investment Fiduciaries. Investors did make trades based on that index, but by 2008 that had ended when the market collapsed. NCREIF continues to generate the index, however.

A second index — which is based on property values through repeat sales — is run by Moody’s using data firm Real Capital Analytics, and is called Moody’s/REAL Commercial Property Price Index. The third, Frischer’s REBOR, was launched in 2006 and uses asking rent data from Cushman and Newmark. It, too, never caught on with traders, but it continues reporting data quarterly. Frischer said he recently received a patent for a method of trading real estate derivatives.

Other attempts to launch indices include Staubach’s partnership with the University of Pennsylvania’s Wharton School, which was active during the boom.

With no action in the U.S., the only active commercial real estate derivatives trading today is in Europe. It is being done through the London-based Investment Property Databank, known as IPD, an index that is pegged to property values. IPD reports that the total outstanding value of derivative contracts in the United Kingdom at the end of 2011 was £4.2 billion, or about $6.6 billion.

Back in the game

Of course, any new effort by BGC Partners and Newmark to push into derivatives will require a lot of groundwork. Even so, a top New York executive at Newmark Knight Frank, speaking on condition of anonymity, said he was not talking with BGC about derivatives. Instead, he said, they were focusing on the basics of merging the two firms together.

Even those plugged into the derivatives world are not privy to what BGC is up to.

“I have not heard anything,” said White. “I reached out to Lutnick and got stonewalled.”

Last month, in BGC’s first earnings report since the Newmark acquisition closed, BGC reported Newmark’s revenues at $54.4 million in the fourth quarter.

That would put Newmark, which is a major player in the Manhattan office market, far behind rivals such as CBRE Group, with revenues of $1.1 billion in the Americas in the fourth quarter, and JLL, with about $509.5 million, also in the Americas in the same period.

Newmark even lags far behind the struggling Grubb & Ellis, which reported revenues of $128.7 million in the third quarter of 2011. (BGC’s agreement to purchase the company is contingent on nobody else coming in with a higher bid and on approval from bankruptcy court.)

But Lutnick has a lofty goal.

“I think [that business] can grow dramatically. I mean, Newmark is [a] platform type of company. I think we could grow to 25 percent market share in real estate,” he said during the Bloomberg Television interview in January. He’s said the derivatives will help grow the overall commercial real estate business.

While there are obviously naysayers, some look at this as the perfect time to create a derivatives market given the extreme uncertainty about whether office rents will spike in the coming years.

Another wildcard that may generate interest in derivatives is the proposed changes to regulations set by the Financial Accounting Standards Board, a non-government business board that sets financial standards for the industry and may be changing its policy on leases.

Under a proposal being reviewed now, lease obligations for tenants would be classified as liabilities. If that new standard is adopted, it could be a boon for the derivatives market, some say.

According to White and others, that’s because large companies might want to shorten lease periods from, for example, 20 years, to 10 years or even five years, but then employ derivatives to hedge against rental price changes.

To prepare for the expected interest, firms are getting back in the game and retooling operations, both on the data and trading sides.

On the trading side, BGC has competition, too. Other firms, including the Wall Street firm Vyapar Capital Market Partners, are looking to trade derivatives. The firms hope to execute trades on behalf of clients such as Goldman Sachs, Merrill Lynch or a hedge fund on one side of the deal, and the tenant or landlord on the other.

In the past, the problem with creating a successful model here was both the complex nature of most lease deals and the inability of the Wall Street firms to create interest and liquidity among their investors in making bets on U.S. property derivatives. In addition, potential investors viewed asking rents and property values as too vague a criterion. But on the leasing side, the net effective rents — which measure the actual rent paid when free rent and landlord contributions are factored in — is too hard to obtain. (Such data, while quietly shared among the city’s biggest commercial firms, is not public.)

Also, those betting on the market want to make sure the indices they are trading against are closely aligned with reality. For example, a bet on Midtown South Class A rents would apply to both the rehabilitated 200 Fifth Avenue and the super-modern 51 Astor Place, now under construction, but an index might not be able to account for that.

Frischer said the asking rent index he created is solid and said that — despite the fact that traders did not use it — it has accurately tracked the market with data going back to 1996.

Custom design

Real Capital Analytics president Robert White

So what will Lutnick’s derivative market look like without an index?

It will be a custom-structured deal that is “just the kind of derivative that’s individual, [that’s] one-to-one and that is going to make the Newmark guys better at talking to clients and doing business.”

In other words, very tailored contracts between parties. Critics said that approach was less valuable to the market, because it would be harder to re-sell such a contract in the secondary market.

Some said the success of this next batch of derivative markets may depend on whether big pension funds, institutional investors or even hedge funds would want to invest in such products.

“I think the only people who will find any interest will be the huge institutions that have the math of scale,” said David Eyzenberg, a principal with the New York office of commercial firm Avison Young. But he added smaller entities could play in the market. “I could see a hedge fund as the counterparty.”

A big question is whether pension funds would be interested, or even allowed by their investing rules to buy real estate derivatives.

But some don’t see big, publicly traded companies like SL Green Realty or Vornado Realty Trust making any bets.

As one real estate professional, speaking on the condition of anonymity, said, “Can you imagine what would happen to their share price if SL Green or Vornado took a short position on Manhattan office rents?”

Frischer, who is also an executive managing director at Newmark (he spoke to The Real Deal for this story only on behalf of Rexx, not Newmark), said this time around firms and investors will want to use hedging tools such as derivatives, in part because of a recognition over the past few years that uncertainty and volatility are now looked at as permanent characteristics of commercial real estate, which investors had traditionally thought of as a stable asset.

“When the sky was falling there was nothing you could do,” Frischer said. “Now that the market has come into some sort of equilibrium, there is confidence out there to manage that volatility. [If] you bring a product to market that they can hedge with, people now will be inclined to use that product.”

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