Hedging exposure to commercial real estate is difficult.
You can short real estate investment trust and commercial mortgage bond indexes, but both REITs and CMBX offer exposure to a limited portion of the market. And prices of both types of securities are influenced by a number of other factors besides commercial real estate prices.
Global Index Group has developed a new product based on the NCREIF Property Index, which measures the performance of some $525 billion of apartments, hotels, industrial, office and retail properties held on behalf of tax-exempt institutions. The synthetic securities, called duETS (Down/Up Equity Trust Securities), allow investors to both go short, or bet on a decline in the index, or long.
In fact, equal numbers of Up and Down securities will be issued. Proceeds are deposited in a trust account with the Bank of New York and invested in Treasurys for two years. At the end of that period, the securities will be valued based on the index level, and funds from the trust account will be used to redeem them.
The product has yet to launch; CBRE Capital Advisors, the exclusive brokers, will issue the first series once it identifies a sufficient number of investors who can agree a price for the securities.
GIG Chief Executive Kelly Haughton believes the timing is good, given the diversity of opinions about the direction of commercial real estate prices. The quarterly total returns of the NPI, which includes 7,364 properties across the United States, have moderated over the past two years as the real estate cycle has matured. (For 2016 as a whole, the total return was 7.97%, consisting of a 4.74% income return and 3.10% appreciation.)
Possible changes in tax policy, an important driver of investment in commercial real estate, add to the uncertainty.
Wall Street has also learned some important lessons from the financial crisis. Because duETS are fully funded securities, there is no counterparty risk, which proved the undoing of the nascent swaps contracts linked to commercial real estate prices during that period.
There are also no restrictions on trading duETS, assuming investors can agree on a price. Once the securities are issued, CBRE Capital Advisors, the investment banking arm of CBRE, will match buyers and sellers in the secondary market, and transactions and pricing will be posted on GIG’s website. The broker can also create or redeem securities from an existing series to meet demand.
And the index itself cannot be gamed, according to Haughton. The NPI goes back to the fourth quarter 1977 and is comprised exclusively of operating (at least 60% occupied) properties acquired, at least in part, on behalf of tax-exempt institutions and held in a fiduciary environment.
Haughton expects initial interest in Down securities will come from debt & hedge funds, with foreign investors potentially acquiring an offsetting amount of Up securities. (Notably, as securities, duETS are not subject to the Foreign Investment in Real Property Tax Act of 1980 income tax withholding.)
Eventually, however, both GIG and CBRE Capital Advisors predict that the broader investment community will use duETS to manage and hedge their exposure to commercial real estate prices, using them to rebalance position size and risk in their portfolios.