CREDL Creates New Investment Tools
September 29, 2006
The Commercial Real Estate Data Laboratory (CREDL) at the MIT Center for Real Estate (MIT/CRE) has developed new methods for analyzing commercial real estate data. These methods track market movements better than previous indexes, showing up-to-date market trends and volatility. But the new indexes are not only for analyzing the market; they can also be used to create a powerful new investment tool real estate derivatives. David Geltner, Director of the MIT Center for Real Estate, discussed the indexes at a talk during the Center's graduation weekend on September 29.
MIT/CRE Research Program Overview
Geltner presented the indexes in the context of the Center's research program, which is composed of three subprograms. The Housing Affordability Initiative (HAI) studies housing affordability with a focus on providing information that addresses affordability in the Boston metropolitan housing market. New Century Development (NCD) explores large-scale projects and the juxtaposition of innovative technology, urban design, and real estate and infrastructure development. Finally, the Commercial Real Estate Data Laboratory (CREDL) measures the performance of commercial real estate. These three programs are interdisciplinary, and interact with the MIT departments of engineering, architecture, and urban studies.
CREDL's researchers use their expertise and links to industry to create innovative new indexes to measure commercial property performance. Currently, CREDL's rigorous, quantitative indexes measure investment performance, but in the future, Geltner said that CREDL will measure operational performance; Dr. Lynn Fisher is working with Equity Office Properties to use their leasing database as a basis for that operational index. Other potential indexes could measure economic performance and environmental or energy performance, Geltner said.
Transaction-Based Index Precisely Tracks Market Movements
The Transaction-Based Index (TBI) is based on quarterly data from the National Council of Real Estate Investment Fiduciaries (NCREIF). The NCREIF data is based on the sales of all investment properties held by pension funds in the United States 5,000 large, prime properties worth a total of $200 billion that are appraised yearly. Over the last 25 years, NCREIF has been producing the NCREIF Property Index (NPI) based on the total rate of return investment performance of these properties the net operating income (rent minus expenses) and the capital value return (change in market value) based on appraisals.
By contrast, CREDL calculates the TBI from actual sales transactions, not appraisals. Compared to the NPI, the TBI shows more volatility, Geltner said, and picks up movements in the market that correspond to particular historical events. "It can more precisely track the actual movements in a market, giving us an index that's more comparable to indexes we have for the stock market or the bond market," Geltner said. Currently, the TBI shows a flattening curve and a possible market slow-down, while the NPI still shows fast-rising performance.
A total return version of the TBI includes income as well as price appreciation. Buildings are aggregated in four sectors: apartments, industrial, office, and retail properties. Three out of the four sectors "flattened out," showing slowing sales and price appreciation in the most recent quarter; retail properties also seem to be reaching a plateau.
TBI Shows Best Price to Sell Quickly
The TBI has also broken the index down into separate supply and demand indexes. "These are movements in what those two sides are willing to pay, are willing to receive for transactions doing deals, " Geltner said. The demand index is more volatile, and moves before the supply index for good reason. "People who are already owning properties are a little more sticky in their re-evaluation of the prices they are willing to sell at," Geltner said. The demand side is a constant liquidity index it shows movements in prices that would allow owners to sell properties as quickly and easily as possible at any point in the market. These prices are determined by examining both the prices and the volume of trading in the market.
New Small Property Index Leads TBI
CREDL is currently working with one of the Center's industry partner firms Real Capital Analytics (RCA) to develop a new prototype index to complement the TBI. RCA attempts to collect every commercial property transaction in the U.S. greater than $2.5 million. While the NCREIF index tracks large institutional sales, RCA properties are mostly small to mid-sized properties traded by private local investors.
This new index will be a repeat-sale index that is also based on transaction price. The prototype's trends appear to lead the NCREIF index across time, even the TBI. The RCA index has seen "an even more exuberant bull market recently," Geltner said, "and shows signs that the bull market may be coming to an end."
Indexes Can Make Money: Real Estate Derivatives
Real estate derivatives based on indexes like the TBI can offer investors more liquidity, lower transaction costs, and more accurate pricing than current investment options, according to Geltner. "It's a way of investing in real estate very quickly and easily, without actually directly buying any bricks and mortar," Geltner said. "These real estate derivatives are basically futures contracts."
Geltner gave the example of an index return swap, where one party takes a long position on the index, and another investor takes the short position. The short position gets a fixed return, while the long position gets paid the index return. For the long position, the derivative is an easy way to reach a target allocation of real estate risk and return in a mixed asset portfolio without any basis risk the investment is in the whole diversified index while the short position would appeal to investors like corporate real estate owners or financial institutions who want to hedge an exposure to real estate. With the short position, owners who worry about property values going down will gain when the property market goes down. "It can effectively be property value insurance," Geltner said.
Real estate derivatives have several advantages over traditional market tools, according to Geltner:
- Derivatives have lower transaction costs than real estate sales.
- Derivatives give real estate investors an opportunity to sell short "for the first time in the history of real estate investment," Geltner said.
- Derivatives provide more liquidity than bricks-and-mortar investments, "especially if a secondary market takes off," Geltner said.
- Derivatives are easier to compare to other asset classes than real estate.
- If real estate derivatives become popular, and their market operates like other derivatives markets, then there will be "price discovery," or more accurate pricing, and capital will be allocated more efficiently due to access to price information.
According to Geltner, there are already contracts based on the NCREIF index. They haven't become popular in the U.S. yet, but the British Investment Property Databank (IPD) index is a very popular appraisal-based index for the United Kingdom. "We think that transaction-price-based price indexes can be a very interesting additional way to define these derivative products," Geltner said.