Economic reports show that housing prices and sales are falling for the first time in many years. Led by a large decline in the West, sales of U.S. existing homes fell 0.8% in December to a seasonally adjusted annual rate of 6.22 million units, according to the National Association of Realtors (NAR). For all of 2006, existing-home sales fell 8.4%, which is the largest annual decline in 17 years.
If the much talked about real-estate bubble isn’t popping, these numbers at least show that housing values move in both directions. And with so much personal wealth tied up in property, thanks to the refinancing boom and interest-only loans, there is greater investment risk in real estate.
With these trends in play, the Chicago Mercantile Exchange (CME) is getting ready to launch commercial real estate futures and options contracts to complement its residential real estate contracts. The Chicago Board of Trade (CBOT) was to launch its own commercial futures contract in early 2007.
The CME’s residential contracts, which were launched May 2006 and based on U.S. residential markets in 10 cities and one composite index, has had a slow start with a daily average trading volume of 45 since inception. However, open interest is climbing, according to Sayee Srinivasan, associate director of the research and product division at the CME. “It’s off to a pretty respectable start and we expect there will be more institutional interest in the coming months.” As of Feb. 7, futures open interest was 1608 while options was 2222.
Typically volatility in an underlying market leads to more activity in the futures. “We hope that will be the case here as our efforts to educate the public on the contracts continues,” Srinivasan says. He adds that when the residential real estate contract was launched, many questioned who would take the other side in a bear market.
“What we discovered was that there were a lot of hedge funds and prop shops and banks who were willing to go long because if the market was bearish, then it was possible to go long really cheap, and they saw it as a possibility for potential profit,” he says.
People trading the CME’s residential real estate products are mostly small institutions. “There’s a lot of money invested in real estate and a lot of risk associated with real estate,” Srinivasan says.
Many pension funds, and others who manage other people’s money, have exposure to the commercial real estate market. Anyone who is long commercial real estate — investment funds, pension funds — could use commercial real estate futures. If you look at the residential market it’s really more about your average person buying and selling homes — there’s very little institutional interest there. Also, builders would look to hedge their risk with residential futures contracts.
Gene Mueller, CBOT managing director of business development, says it’s harder to create a residential real estate futures contact than a commercial one. The challenge with real estate futures, he notes, is houses are different than say #2 yellow corn. “With real estate you can drive through any residential neighborhood and there are all types of different houses, and even within those houses there are different levels of quality,” Mueller says.
Commercial real estate represents one of the most significant asset classes in the United States. The NAR in 2005 estimated the value of all domestic commercial property at $5.3 trillion.
“Futures and options contracts are a means to transfer risk, so if you are a pension fund that wants to add more exposure to commercial real estate because you haven’t reached your target allocation to that market, there are different ways to go about that: you can invest in commercial real estate directly or you can buy commercial real estate futures or options contracts and still get exposure to the commercial market,” Srinivasan says. “These are the people who will be buying these contracts. If you take a large institution that has a huge investment in a commercial real estate market and is concerned that prices will fall during next the three or four years, it can sell the futures contracts to hedge against the risk of falling prices,” he says.
The CME is teaming up with Global Real Analytics (GRA) to launch CME U.S. commercial real estate futures and options based on the GRA Commercial Real Estate Indexes. Ten quarterly cash-settled contracts will be available: a national composite index, five geographic regional indexes and four national property type indexes. The contracts are scheduled to begin trading in the first quarter of 2007.
“There are two natural longs and shorts in the commercial market: the short would be the person who wants to hedge against a drop in prices and the long is someone who expects prices will go up and wants to gain exposure to that asset class,” Srinivasan says.
While they seem like mostly institutional contracts, retail traders will be able to trade them. “It’s something a lot of high net worth individuals with financial advisors could use,” Srinivasan says. “The average investor does not know a lot about the commercial real estate market; they know the residential market better because they probably own a house.” And at $5,000 for a contract, a retail trader can gain access to the commercial market.
While the CBOT is not ruling out residential futures, for now its focus is on launching a new stock index futures contract based on the Dow Jones U.S. Real Estate Index. The electronically-traded Dow Jones U.S. Real Estate Index futures contract, which will be launched during the first quarter of 2007, will allow market participants to capitalize on changes in the real estate sector of the stock market and manage commercial real estate exposure.
The contract will settle to the value of the Dow Jones U.S. Real Estate Index, an index comprised primarily of Real Estate Investment Trusts (REITs). REIT securities serve as an accurate proxy for the underlying U.S. commercial real estate market because lease rates, vacancies, development costs and property transaction values are all reflected in REIT share prices.
“We talked to REIT managers, people would want real estate exposure like pension funds and commercial real estate developers and what we found is that there are a lot of people who want exposure to real estate without actually wanting to invest directly in certain property,” Mueller says.
Srinivasan says there’s a lot of hedging interest in both residential and commercial real estate contracts. Builders use the residential contracts to hedge. If a builder knows a certain subdivision will be finished in December 2007
and is concerned about falling prices, he can look at the futures contracts. “Let’s say the futures contracts are priced, for example, for an expected 5% drop in prices in the Chicago area by December 2007,” Srinivasan says. “As a builder I can say ‘that 5% drop is something I can live with, but if it’s going to be more than 5%, that’s not something I’m willing to deal with.’ So what he can do is sell the futures contract to lock in the price at which he’ll be selling the houses in that subdivision.”
More new futures contracts fail than succeed, but given the amount of leveraged money tied up in real estate — both commercial and residential — it is amazing that these haven’t been launched before at least in Chicago. The purpose of futures contracts is the transfer of risk and there is plenty of risk in the property markets.
