A look at developing markets for managing real estate risk

By Ryan Chittum

With all the volatility in the investment market, you might think real estate executives would be looking to hedge funds to measure risk. According to industry professionals, though, two of the main ideas that hedge funds typically use to do just that—alpha and beta—aren't being widely applied in real estate. Not yet anyway.

Beta is a measure of the volatility of an investment relative to the overall market. A beta of 1 means the investment tracks market movements exactly. The more volatile it is relative to the broader market, the higher the beta. The less volatile the investment relative to the market, the lower the beta.

Alpha is the measure of an investment's return over the market's return. It's essentially a way to gauge operator or investor expertise. Investment managers find alpha by exploiting inefficiencies in markets. Developers and real estate owners produce it by performing better than their average competitor.

Chasing Alpha

"Everyone in real estate thinks that somehow they can produce alpha," says Jon Southard, principal and director of forecasting at Torto Wheaton Research. "I don't know how that can be."

Indeed, Ronald W. Kaiser, a director at investment firm Bailard Inc., notes that the sum total of alpha in a market is zero. If one person wins, someone else must lose.

Still, the single-minded search for alpha goes on. Jeff Tack, a former senior portfolio manager at LaSalle Bank in Chicago, says alpha in real estate can be created a number of ways. "You generate alpha because you've got a process that makes the situation more efficient," he says. "Typically, you have a better system, something you've created, invented or done, such as superior property management skills. You can have a better model that lets you pick properties to buy or sell, or somehow you have a lower borrowing cost than all of your competitors."

Kaiser says fund managers can seek to create alpha by such acts as varying their leverage over the cycle and timing when they hold a higher percentage of cash as compared to property. Creating alpha can be as simple as adding leverage to a portfolio because leverage magnifies the effects of overall market returns.

Hedging Alpha

However, more sophisticated concepts of hedging alpha risk with beta, long familiar in the hedge fund world, are largely absent from real estate.

"I honestly haven't heard it applied to real estate before. The reason is that the value of building prices is notoriously hard to hedge," Tack says.

Joseph Pagliari, a principal at Citadel Realty Inc. and a professor of real estate at the University of Chicago Graduate School of Business, agrees, "it is often exceedingly difficult to precisely apply the theoretical constructs of alpha to investments such as real estate."

One of the problems in real estate is finding an appropriate index that investors can short to hedge the risk of their alpha strategy, according to Tack. One possibility, certainly, is shorting a REIT index. However, some investors say the effectiveness of that strategy is diminished by the increased volatility in REITs in the last couple of years.

The reasons for the increase in REIT beta go back several years, says Matthew Ostrower, a commercial real estate analyst formerly with Morgan Stanley. The inclusion of REITs in the Standard & Poor's 500 stock index inherently increased beta for the sector in part because of its inclusion in index funds.

Derivatives offer hedging opportunities for real estate portfolio managers as well. In particular, portfolio managers can benefit from a derivative-enhanced yield by strategically selecting products based on property type or geography. Additionally, real estate derivatives can be used by developers to hedge development risk, or as a low-cost synthetic real estate investment for wealthy individuals, families and foreign investors.

Another possibility is to hedge using indexes of credit-default swaps—financial derivatives that investors can buy to insure debt—like the CMBX. The problem with this approach is that these credit swaps are imperfect vehicles with which to hedge equity investments. "You can model how the swaps perform relative to equity, but in reality there's not a close one-for-one inverse relationship between the two," he says.

Another problem with using the CMBX is that it requires regular payments, typically on a quarterly basis, Tack says. If losses increase, they have to be marked to market and credit-default swap holders must put up more money. "The problem with real estate is it's not liquid," he says. "You can do that with REITs, but can't, for example, with most office buildings."

Southard says another major issue is that the CMBX does not really reflect what's going on in commercial real estate right now, in large part because of the crunch of the credit markets. "It's becoming unmoored from the fundamentals," he says. "What we hearfrom Wall Street is that it's dominated by hedge funds trading with other hedge funds. In some sense, the CMBX becomes just a number."

One developing market that could help provide vehicles for real estate equity hedges is the commercial real estate derivatives market, which is in its infancy in the United States, though the United Kingdom's is more mature. "It's very immature on the equity side," Tack says. "On the debt side, it's also only three or four years old."

The idea behind a real estate derivatives market is to further increase the liquidity that has transformed the once illiquid real estate market by allowing developers and owners to hedge their property investments in specific markets or in real estate as a whole. Various indexes, including REXXindex and Moody's REAL Commercial Property Price Index, are in a race to become the standard to track property performance.

To address the confusion on this fairly recent investing approach, a new organization, the Real Estate Derivatives Special Interest Group, was created in late 2007 to offer insight and perspectives to the market and address frequently asked questions on the use and implementation of commercial property derivative products.

"They're very much embryonic," Ostrower says. "But those property-derivatives indexes are going to be huge. From a theoretical perspective it's an incredible solution for many players," some of whom he says are going long or short REIT index movements, a much more blunt instrument.

Other analysts agree with that assessment. "Derivatives play a major factor in every other institutional capital market, and people are saying that it's just a matter of time until real estate participates," Southard says. "There are some folks with proposed and existing indexes that you can use to do swaps."

One of the most intriguing possibilities of these markets is that they will allow developers to hedge their building risk against potential future market-specific downturns. Some envision a time when investors will be able to hedge real estate investments in specific blocks or even in specific buildings.

"There's really no reason why a developer couldn't say, 'Instead of putting it all on the fact that the market's going to be great by the time this building finishes, I can hedge a little bit and say I may be building a great building, but if rents are lower than I think, then I'll actually not lose as much. So I can hedge my alpha but still make my beta,'" Southard says.