US Property Derivatives Market to Open

This morning’s Financial Times reported that four big banks have set up a property derivatives trading platform in the US. With $450 trillion (yes, trillion) in outstanding contracts, the property market dwarfs the $60 trillion total value of the stocks traded on the world’s 10 biggest exchanges. Until recently, though, there has been no derivatives market attached to property. This is, in general, a good thing, but it is not without a downside.

Commercial property index contracts have been traded in the UK for a couple of years now, but the US is the big market to crack. According to the FT, Credit Suisse, Goldman Sachs, Merrill Lynch and Bank of America have teamed up with the National Council of Real Estate Investment Fiduciaries (NCREIF) to establish such a market. The NCREIF will provide data from its property indices to the banks, who will then figure out how to profit from them.

Simply, a derivative is a financial instrument that is valued in relation to an underlying asset or price index; for example, a soybean futures contract is a derivative, a stock option is another. In this case, a contract or option on a property or a collection of properties will be created and traded. Not just the big banks will get involved, as hedge funds and insurance companies are aching to get into property without actually having to own and maintain the building(s).

There could even be a benefit to consumers. Suppose a family wants to buy a house in a given neighborhood, but will need a couple of years to save up for it. Normally, they would save and hope there’s a house available when they were ready, in which time the price could have soared out of reach. However, if they were to buy an option and lock in the price, a great deal of risk would be removed from their lives.

The downside, of course, is the same downside any market has. Contrary to what is taught in freshman college economics courses, markets are not efficient. They are self-correcting, which isn’t the same thing. They overshoot equilibrium levels, they are subject to premiums created by speculators activity, and they are subject to panics. Moreover, property is not as readily commoditized as other assets (“location, location, location” prevents that). All the same, this market will allow the spread of risk across more portfolios, and that is always a good thing.

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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