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Areal estate derivative is afinancial instrument whose value is based on the price ofreal estate. The core uses for real estate derivatives are:hedging positions, pre-investing assets and re-allocating aportfolio. The major products within real estate derivatives are:swaps,futures contracts,options (calls and puts) andstructured products. Each of these products can use a different real estate index. Further, each property type and region can be used as a reference point for any real estate derivative.
The most basic form of real estate derivative is a swap transaction, in which one investor, or one side, goeslong and the other side goesshort (finance). An investor would want to execute a swap if they thought that the market, or sector, was likely to appreciate, in which case they would go long. Alternatively, if an investor’s view was that the market would depreciate from that point, they would go short, or take the other side of that trade.
One can apply options to real estate. A real estate Option is a contract based on atime horizon and an expectedproperty value. It is developed based on financial options contracts and adopted to individual real estate assets.
With the real estatecall option, the property owner can sell an option in exchange for debt-free cash today. Investor, who buys the real estate call option benefits from property price appreciation and price volatility.
With the real estateput option (selling price decline insurance), the investor can sell an option thus the investor underwrites price decline insurance. The property owner, who buys the option, is protected against price decline of the property.
Owning real estate assets is costly, and the transaction costs associated with purchasing commercial real estate can be prohibitive. Typical transaction costs can equal 500 - 800basis points per transaction.[citation needed] Industry estimates suggest that transaction costs for commercial real estate easily surpass $10–$12 billion annually.[citation needed] Since the US real estate derivative market is new, the transaction costs are at this point variable. However, based on derivatives in other markets, it is anticipated that the costs will be well below the 500-800 basis points required to invest in actual real estate.[citation needed]
The market for real estate derivatives was long overdue.[citation needed] Real Estate is the only majorasset class that only recently developed aderivatives market.[citation needed] According to the Pension Real Estate Association’s Plan Sponsor Research Report, pension funds allocate approximately 6.0% of their assets to real estate, making it one of the largest investableasset classes, after equities andfixed income.[citation needed] Because of the significanttransactions costs involved with investing in real estate, derivatives can, but also might not, improve the efficiency of the market.[citation needed]
The market for US real estate derivatives, while in a nascent stage, made significant progress in 2007[citation needed]. There are now a diverse set ofindices and methodologies being used to create and structurereal estatederivatives, for both residential and commercial real estate.[citation needed]
In the UK, the market for property derivatives did not begin until 2004. However, since the market’s inception, the growth has been significant. Through the third quarter of 2007, trades with an outstanding notional value of 7.9 billion pounds have been executed. The U.S. market is still emerging, and has been limited somewhat over the last year by the global credit crunch and uncertain values ofmortgage-backed securities. However, the market in the U.S. is now emerging quickly, with over $500 million worth of transactions to date in 2007.
Taking the AUD 139.5 billion in Australian residential and commercial property sales recorded in 2006, and applying a 1-to-1 derivatives-to-underlying ratio, the potential PD market would be larger than the $89 billion Australian credit derivatives market. A 2-to-1 ratio would make it more active than the $215 billion interest rate options sector, and a 3-to-1 ratio would put it within reach of the $472 billion ASX options industry.[1]
RP Data-Rismark indices is regarded as the market leader of Australia's Property Derivatives Market.[2]
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