Transcript Slide 1

Property Derivatives:
Whassup?
NCREIF Spring Conference
Seattle, WA
June 14, 2007
Panelists
NCREIF
Blake Eagle, Moderator, NCREIF (Retired)
Phil Barker, CBRE/GF I
David Geltner, MIT
Jeff Havsy, PPR
Webster Hughes, B of A (consultant)
Jim Valente, Broadway Partners
Licensed Dealers
NCREIF
 Banc of America Securities LLC
Edwin Anderson
 Credit Suisse Securities (USA) LLC
Jason Fruchtman
 Deutsche Bank Securities, Inc.
Malin Wong
 The Goldman Sachs Group, Inc.
Jeremy Primer
 Lehman Brothers Inc.
John Beaman
 Merrill Lynch, Pierce … Incorporated
Kiva Patten
 Morgan Stanley
Ahsim Khan
Why all the Excitement?
The Global Derivative Market
Notional outstanding as of Q2 2006
US$ 481 Trillion
$20
$36
$38
Equities,
$7.0
$6
Foreign
Exchange,
$0.2
Foreign Exchange
$7
Interest Rates
Equities
Commodities
Credit Default
Other
$262
OTC Derivative Market: $397 Trill.
Interest
Rates,
$77.0
Exchange Traded Derivatives: $84 Trill
Commodities and CDS not included
Source: WWW.BIS.ORG
4
Why all the Excitement?
Growth Rate of Property Derivatives in the U.K.
IPD Index Statistics
£16,000
£14,000
£12,000
£12,500
£10,000
£8,000
Projected for remainder of 2007
Total Notional Trades completed
£6,000
£3,861
£4,000
£260
£2,944
£2,000
£850
£0
2004
2005
2006
2007
5
Why all the Excitement?
Market Values - Underlying Vs. Derivatives
United States
% of Underlying
Market
World
% of Underlying
Market
GDP
12.5
-
44.5
-
Equities
17.0
37.1
36.1%
38.8%
Equity Derivatives
6.1+
14.4+
Fixed Income
27.4
45.0
459.5%
Fixed Income (Interest Rate) Derivatives
Commercial Property
Commercial Property Derivatives
Potential
722.1%
126.0
324.9
5.3
15.0
1.9
36.1%
5.8
38.8%
+ : Numbers include OTC and exchange-traded equity indexes, but not exchange-traded equities.
Sources:
www.bis.org www.imf.org www.cme.com www.bondmarkets.com
6
History of RE Derivatives
UK property derivatives have taken off.
Physical Market Derivative Market Notional
UK Commercial Real Estate
US$1.6 Trill
US$13 Bill
UK Annual R.E. Turnover
US$64 Bill
US$30 Bill *
* Extrapolated from Q1 2007 IPD Results - $6 Billion
•
•
•
14+ International banks active (18-20 looking)
End Users involved
•
•
British land
Prudential Property Investment Managers
•
•
AXA
ING
•
•
Threadneedle
Quintain
•
Morley Property Fund (UK #3?) seeds 1st ever RE derivative hedge fund
Inter-sector and European transactions
• London City Office/ retail/Industrial
•
•
French IPD trades
UK market started in 2005, with slower growth than the US market has seen.
7
Expansion into the U.S. Market
• NCREIF Issues licenses to trade derivatives on its indices.
• Credit Suisse agrees to allow other dealers to help develop market
• 7 banks now signed up with more to follow
• ML – GS – CS – LB – MS – BOA – DB
• Synergies to CMBS / RMBS operations
• Hedge fund activity – cross asset class correlation
• Brokerage operations form to help develop market.
• Provide pricing platform – similar to other financial asset classes
• Form partnerships with traditional real estate brokers
• Immediate expansion in trade volume
• Total return swaps executed against NPI
• Sector specific swaps
• Inter-sector swaps executed
• Traditional real estate players involved
8
Specific Trade Example
One Year New York Office Proposal
•
Client wishes to obtain exposure to the New York Metro (NYM) area
office market, initially for 1 year (starting Jan 1st 2007).
•
Client would be prepared to enter into an interest rate swap based
upon the NCREIF definition of NYM (MSA35644).
•
Client would pay a flat rate of 13.00 pct fixed, and in return receive the
floating NCREIF return for 2007 for this region, in a notional USD
amount of $50-100MM.
•
There would be no exchange of money or cash flow during the life of
this deal.
•
Upon maturity the difference between the two interest rates multiplied
by the notional value of usd agreed upon will be payed or received.
9
Specific Trade Example
Total Return Swap On New York Metro Office
•Term = 1 Year (Calendar Year 2007)
•NCREIF New York Metro Office total returns vs. 13.00 Pct fixed
•Notional amount = US$ 50-100 MM
Receiver of
index (Long)
Property Fund
Return on NCREIF
NYM INDEX
13.00 Pct Fixed
Bank
Return on NCREIF
NYM INDEX
Payer Of Index
(Short)
(Property owner)
13.00 Pct Fixed
The difference between the fixed return Vs. the floating NCREIF return multiplied by the
notional amount, will be exchanged between counterparties at the maturity of the deal.
One time exchange of cash flows - 5 days after publication of NCREIF results for 2007,
Payable in USD amount.
10
Pricing of derivatives…
Equilibrium Swap Price
Consider a total return swap…
Suppose:
• LIBOR = 5%,
• Real estate index equilibrium risk premium (over
LIBOR) is 2%.
R.E. mkt equilibrium expected total return is:
LIBOR + RPS = 5% + 2% = 7%.
Index consensus expected total return is:
E[rS] = LIBOR + RPS = 5% + 2% = 7%.
Long position will pay price F as high as (no higher
than):
FL = LIBOR = 5%. Why?...
Geltner MIT/CRE © 2007
Pricing of derivatives…
Equilibrium Swap Price
Long position will pay price F as high as (no higher
than):
FL = LIBOR = 5%. Why?...
Will earn 5% on LIBOR bond of notional amt,
Plus expected 7% on index return,
Minus price of F = 5% :
 Expected return on overall position (covered
long swap):
= 5% + 7% - 5% = 7%
= Equilibrium (“fair”) expected return on investment
with risk equal to that of RE index.
Geltner MIT/CRE © 2007
Pricing of derivatives…
Equilibrium Swap Price
Short position will take price F as low as (no lower
than):
FS = LIBOR = 5%. Why?...
Will earn expected 7% on covering real estate of
same risk as index,
While paying expected 7% on swap,
Plus receive F = 5%:
 Expected return on overall position (covered
short swap):
= 7% - 7% + 5% = 5% = LIBOR
= Equilibrium (“fair”) expected return on investment
with risk equal to that of LIBOR (short cancels RE
risk exposure).
Geltner MIT/CRE © 2007
Pricing Lesson:
• The equilibrium (“fair”) swap price is LIBOR (for a
total return swap).
• Note: This is not expected return on real estate
index.
• Fair price is LIBOR Minus RE Income Return (for
capital return swap).
• Above price rules apply when/if index represents
current equilibrium price in property market.
• This will often not be the case especially for an
appraisal-based index.
• Then what?...
Geltner MIT/CRE © 2007
Equilibrium Swap Price with Lagged Index
Now suppose:
• LIBOR = 5%,
• Real estate index equilibrium risk premium (over
LIBOR) is 2%.
• Index lags mkt, giving index +4%/yr “overhang”
during contract period (RE mkt has been rising
strongly)…
R.E. mkt equilibrium expected total return is:
LIBOR + RPS = 5% + 2% = 7%.
Index consensus expected total return is:
E[rS] = LIBOR + RPS + lag = 5% + 2% + 4% = 11%.
Long position will pay price F as high as (no higher
than):
FL = LIBOR + lag = 5% + 4% = 9%. Why?...
Geltner MIT/CRE © 2007
Equilibrium Swap Price with Lagged Index
Long position will pay price F as high as (no higher
than):
FL = LIBOR + lag = 5% + 4% = 9%.
Why?...
Will earn 5% on LIBOR bond of notional amt,
Plus expected 11% on index return
Minus price of F = 9% :
Expected return on overall position (covered long
swap):
= 5% + 11% - 9% = 7%
= Equilibrium (“fair”) expected return on investment
with risk equal to that of RE index.
Geltner MIT/CRE © 2007
Equilibrium Swap Price with Lagged Index
Short position will take price F as low as (no lower
than):
FS = LIBOR + lag = 5% + 4% = 9%.
Why?...
Will earn expected 7% on covering real estate of
same risk as index,
While paying expected 11% on swap,
Plus receive F = 9% :
 Expected return on overall position (covered
short swap):
= 7% - 11% + 9% = 5% = LIBOR
= Equilibrium (“fair”) expected return on investment
with risk equal to that of LIBOR (short cancels RE
risk exposure).
Geltner MIT/CRE © 2007
Other Pricing Considerations:
• Private values:
– Party/counter-party complementary beliefs (e.g., bullish &
bearish expectations on long & short sides, alpha
expectation on short side…).
– “Insurance”/hedge value (short position).
– Cost of basis risk (short position).
– Transactions/mgt cost savings (long side).
– Diversification (long side).
• Liquidity values/Preferred habitat:
– Suppose long parties tend to want longer term contracts
than short parties:  term price curve.
---------------------------Any 2 parties can agree to whatever price they want (especially
in OTC trading)!
Geltner MIT/CRE © 2007
The Derived Market Return — Drivers of Performance
Change in Supply
• Value/Cost
• Cost of Capital
• Depreciation
=
SF Supply
Rent Drivers:
• Vacancy
– Level
– Momentum
• Demand
• Inflation
NOI Drivers:
• Rent Growth
• Past Vacancy
• Demand
• Inflation
Current
NOI
Last
Period’s
Value
Yield
+
Vacancy
SF Demand
Users
x
Usage
Source: Property & Portfolio Research (PPR)
PPR
www.ppr.info
Value Drivers:
• Demand-Driven
Capital Flows
• Earnings Indicators
– Vacancy
– NOI
• Capital Markets
– Risk Premium
– Opportunity Cost
– Inflation
Value
% Change
in Value
=
Total
Return
NCREIF - Real Estate Swap Prices *
* Contains actual market
quotes and estimates
for illustration
purposes only
NPI
Term/Yrs
Basis Points
Percentage
Percentage
LIBOR Plus
Total Return
Historical Returns
Bid Mid Offer
Bid
Mid
Offer
Year
Return
1
400
475
550
9.50
10.25
11.00
2004
14.49
2
280
320
360
8.25
8.65
9.05
2005
20.06
3
225
275
325
7.75
8.25
8.75
2006
16.59
Sector Swaps
LIBOR Plus
Term/Yrs
Office
Bid
Mid
Offer
Year
Return
1
600
750
900
11.5
13.00
14.5
2004
12.02
2
450
550
650
10
11.00
12
2005
19.46
3
400
500
600
9.5
10.50
11.5
2006
19.16
Bid Mid Offer
Bid
Mid
Offer
Year
Return
1
250
300
350
8.00
8.50
9.00
2004
22.95
2
180
230
280
7.25
7.75
8.25
2005
19.98
3
140
190
240
6.90
7.40
7.90
2006
13.35
Bid
Mid
Offer
Year
Return
Term/Yrs
Apartment
Bid Mid Offer
1
200
250
300
7.5
8.00
8.5
2004
13.04
2
125
175
225
6.7
7.20
7.7
2005
21.15
3
100
150
200
6.5
7.00
7.5
2006
14.63
Bid
Mid
Offer
Year
Return
Term/Yrs
Industrial
Historical Returns
Bid Mid Offer
Term/Yrs
Retail
Total Return
Bid Mid Offer
1
350
400
450
9
9.50
10
2004
12.07
2
280
330
380
8.25
8.75
9.25
2005
20.31
3
240
290
340
7.85
8.35
8.85
2006
16.96
20
Property Derivatives:
Whassup?
NCREIF Spring Conference
Seattle, WA
June 14, 2007