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"Derivatives make markets more complete - that is, they make it possible to hedge risks that otherwise would be unhedgeable. ... [R]isks are born by those who are in the best position to bear them and firms and individuals can take on riskier but more profitable projects by hedging those risks that can be hedged. As a result, the economy is more productive and welfare is higher."
- René Stulz, "Should We Fear Derivatives?" Journal of Economic Perspectives, Summer 2004
OVER THE PAST DECADE, U.S. INSTITUTIONAL REAL ESTATE HAS evolved into a dynamic, more widely accepted mainstream asset class. The securitization revolution of the 1990s helped produce today's robust public real estate investment trust (REIT) and commercial mortgagebacked securities (CMBS) markets. It also has facilitated major capital flows into real estate in recent years that have strengthened linkages between private real estate asset markets and wider national and global capital markets. This shift has transformed real estate financial structures, capital sources and investment products.
The real estate sector continues to evolve at a rapid pace, with the emerging commercial property derivatives market being the latest innovation. There is significant interest by many real estate market participants in the development of commercial property derivatives. Investors are watching with interest to see if this new way to gain exposure to the real estate asset class and hedge private real estate risk will materialize and revolutionize the institutional real estate world, as it has in stock and bond markets around the world. Real estate is the last major asset class without a significant derivatives market. Property derivatives represent a new way for investors to gain or reduce exposure to the real estate asset class, quickly and without directly buying or selling properties, while relying on the performance of a real estate return index. The speed and ease of execution, reduced upfront capital requirement and ability to protect real estate portfolios on the downside provide added flexibility in executing real estate investment and portfolio risk management strategies. It seems to be a natural next step in the evolution of real capital markets, continuing the transition from a private asset class characterized by high transaction costs and the inability to sell short to one with significant public market integration...