Hedge The Office Building

September 07, 2006

The real estate derivatives market takes a huge step forward, as CME announces plans for commercial real estate derivatives.

Earlier this year, there was no easy way to hedge the value of real estate. My, my, how times have changed.

After launching the world's first house-price futures in May, the Chicago Mercantile Exchange (CME) announced plans this week to launch futures and options tied to the value of U.S. commercial real estate. Taken together, the two products open up markets worth over $24 trillion, offering the first easy, diversified means to hedge real estate ... ever. The commercial futures are expected to launch in the first quarter of 2007.

The new products will be based on the Commercial Real Estate Indexes (CREX) from Global Real Analytics (GRA). The CREX indexes are transaction-based indexes that measure the change in price-per-square-foot for sales of four types of commercial buildings: offices, warehouses, apartments and retail space. The indexes exclude certain "non-core" types of buildings, such as hospitals and laboratories, which are influenced by special pricing trends.

The use of square-foot measurements, rather than whole building sale prices (as the S&P Case-Shiller residential price indexes do), prevents the index values from being skewed by the dollar value price of large properties. Large properties do have a commensurately larger weighting in the calculation of the index, however, as the indexes use what amounts to a market-cap weighting strategy.

The indexes aggregate sales data over three-month periods, with the final value of the indexes will be released four times a year, in February, May, August and November.  As an example, the contract released in November will reflect sales from August through October.

The indexes only track values in certain large urban and sub-urban markets, and only in certain regions.  Generally speaking, the indexes cover the two coasts and the growing southern metropolitan regions; the middle of the country is by-and-large skipped for now.

Sales are also screened to exclude extreme high- and low prices, that GRA believes generally reflect insider arrangements (say, between family members passing down assets or businesses, etc.).

The full methodology paper is available here.

The CME envisions ten sets of options: a "National" options tracking the total market, five regional indexes tied to the Northeast, Midwest, Mid-Atlantic South, Pacific West and Desert Mountain West regions, and four "property type" indexes tracking national trends in the four property sub-types mentioned above.

The commercial real estate market is very different from the residential market, as it is driven less than by changes in interest rates and consumer income and more by business trends. Commercial prices rose in the second quarter, for instance, even as residential markets tumbled.

The residential futures have been slow to take off, as is typically the case with new futures contracts.  According to the Chicago Tribune, just 3,200 contracts have traded hands since the products launched four months ago. Nonetheless, the CME has repeatedly expressed confidence that strong demand in the products, and they must, as the commercial products will likely face an even more difficult time attracting a critical mass of volume.


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