Euromoney Liquid real estate March 2007
The Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBoT) have embarked on separate and different approaches real estate derivatives and could end up competing with one another in advance of their likely merger.
Together they account for more than 85% of US futures exchange trading. Their $9 billion deal is subject to approval by the antitrust division of the Department of Justice.
The CME was first to enter real estate derivatives in March 2006 with futures and options trading based on S&P/Case-Shiller’s residential indices, which include 10 metropolitan areas and one composite, and offer four quarterly expiration dates a year based on $60,000 one-year contracts. Response to the products has been solid rather than spectacular: from March 2006 to January 2007, a notional $350 million was traded in real estate futures and options on the exchange with an average daily volume of 45 contracts in 2006.
According to Sayee Srinivasan, director of research and product development at CME, buyers include builders who want to limit downside risk while benefiting from any future upside by buying put options and mortgage bank securities traders concerned about default risk. Retail buyers are said to be using the futures market to lock in a future sales price for a property while high net worth investors are hedging against the bear market.
However, the institutional market remains aloof. “Ultimately we would like to attract institutions to the market,” says Srinivasan. “US residential real estate prices as reflected by the S&P/Case-Shiller
Home Price Indices have a correlation of less than 1.0 when compared to US equity and bond markets, so it would be a great source of diversification for them.” Similarly, while about 15 firms have provided liquidity, there are few large institutions in the market. Nevertheless, liquidity has improved dramatically with bid-offer spreads on a $50,000 contract falling to $150 from $2,500 when the market launched.
CBoT seizes intiative
CME’s website includes information about plans to launch Commercial Real Estate futures and options based on the Global Real Analytics Commercial Real Estate Indexes but Srinivasan says that no launch date is imminent. Instead, CBoT has seized the initiative in commercial real estate with the launch of a futures contract linked to the Dow Jones US Real Estate Index at the end of February. As an index based on 91 property stocks, 84 of which are Real Estate Investment Trusts (Reits), it has proved controversial.
“Reits are simply not an accurate proxy for real estate,” says one veteran of the UK real estate market. “They trade at huge discounts or premium to their asset value depending on the appetite of the equity markets and, more specifically, are closely correlated to equity markets in direct contradiction of the needs of most real estate investors.”
Gene Mueller, director of marketing at CBoT dismisses such criticism. “In order to qualify for their tax exempt status, Reits must pass on 90% of their income to shareholders,” he says. “Consequently, they are an accurate reflection of the returns available in the real estate market.” Indeed, Mueller believes that a Reit-based index could be a more accurate reflection of market movements. “Real estate is heterogeneous and consequently there’s always going to be some skew on valuations or transactions.”
Most importantly, CBoT believes that the past form of Dow Jones US Real Estate Index will stand it in good stead. “There is already a successful exchange traded fund based on the index and we believe that futures and options based on the same index make sense,” says Mueller.
CBoT appears to be aiming for the same high net worth and retail audience as CME but hopes to attract pension funds and other institutions rapidly. “This is a low cost way to increase or decrease real estate exposure without triggering a tax event by selling the underlying and that should be attractive to institutions,” says Mueller. Only time will tell if CBoT has taken a wise course, but just one futures contract tied to the index was traded during the first day of trading in late February and none on the second day, according to reports
