Commercial real estate development, never the surest and steadiest of enterprises at the best of times, is getting a bit of help on risk management.
A new futures contract to be offered this month on the Chicago Mercantile Exchange will give developers an opportunity to help mitigate risks through derivatives, sophisticated financial instruments that let investors bet on the direction of the market.
The exchange, which last year began trading in residential housing futures, is expanding its market. The move is attracting some interest from a New York brokerage firm, giving real estate investors options beyond bricks and mortar and shares in REITs.
The Chicago Merc program will trade futures contracts, which it claims are the first to allow investors and speculators to protect or gain exposure to the $5.3 trillion U.S. commercial real estate market.
While the most typical futures investors are institutional investors, such as pension funds and university endowments, the contracts allow anyone to gain real estate portfolio exposure and hedge core property types based on geographically determined markets.
The idea behind a futures contract is simple: The buyer agrees to purchase a specified amount of something — say, a ton of pork bellies — on or before a given date. If the price goes up in the interim, then the buyer gets that commodity at below-market cost. But if the price falls the buyer is stuck overpaying. Of course, most investors — even the big institutional ones — can’t store a ton of pork bellies. So while some futures contracts conclude with the physical delivery of a commodity, the vast majority expire unexercised, are settled with cash or involve nonphysical financial instruments like the S & P 500 index.
As a hedging tool, the futures contracts could help protect developers of larger buildings, who are vulnerable to price declines between the construction of the first and last home or apartment in a large project.
“It’s a big source of risk,” Sayee Srinivasan, associate director of the Chicago Mercantile Exchange’s Research and Product Development Group, said of the real estate market. “Our view has been to come up with products to manage that risk.”
The Chicago Merc’s product aimed at the residential market, which debuted last May, has gotten off to a slow start, however. The contracts are tied to price indices that track home prices in 10 major metropolitan areas. As of last month, there were 6,300 contracts traded since operations began, with an average of 45 a day. The city with the most contracts traded has been Los Angeles, with 1,275, followed by Miami with 1,149 contracts. New York has traded 750 contracts to date. The total dollar value of trades amounts to $325 million, Srinivasan said. He said the exploration of the commercial program was an outgrowth of the residential program. While the exchange is trying to tap a market with a new contract, it’s likely if it doesn’t get sufficient interest, the market maker will stop offering the contract.
Back east, Domain Properties will be establishing Domain Futures LLC in order to be a New York-based broker in the real estate futures market.
According to Frank Gerage, director of real estate risk management at Domain Properties, his firm saw the Chicago Merc’s market as natural extension of their existing work in real estate.
Gerage said utilizing futures is best for developers of larger condominium complexes, who could see declines in prices during the course of selling their units.
The Chicago Merc will unveil the commercial contracts in New York on Jan. 18, following a presentation to the full Real Estate Board of New York. Gerage said information about the market was presented to REBNY executives a few weeks ago.
A REBNY spokeswoman said the group hosted a meeting but that the group had no further comment nor further involvement.
Gerage and Srinivasan reported interest from real estate professionals as well as investors in New York and nationwide. Srinivasan said he has received calls from institutional investors, REITs and real estate companies about investing in the market.
Yale University Economics Professor Robert Schiller, who helped develop the housing futures contracts system, said real estate was ripe for other derivative investment products.
Schiller said he has been working with Goldman Sachs to create swaps and notes to trade on single-family homes, a product line that is expected to debut this year. He also envisions a swaps market being created for the commercial real estate market.
“These things are coming,” Schiller said. “They are sophisticated products; once we get used to them, they won’t be any different to trade than others.”
The Chicago Merc residential system is tied to the S & P/Case-Schiller Home Prices Indices that tracks home prices in 10 major U.S. cities. All futures and options are cash settled to the index. Schiller co-founded the price index in the early 1990s and has been calling for a futures market for the housing industry for over a decade.
Schiller said the delay in tying a futures market to housing had been tied to the settlement process. Unlike the commodities market, which can be settled with a clear commodity, such as corn or wheat being delivered, housing futures are based on prices and a cash settlement system had to be developed.
“I think the final list of investment products is less than half developed,” Schiller said. “There will be an array of products in real estate.”