By Christopher M. Wright

NAME: Michael Giliberto, Ph.D., CRE, FRICS TITLE: Managing Director, Senior Portfolio Manager for Real Estate Multi-Strategy Products at JPMorgan Asset Management BORN: 1950 EXPERIENCE: Giliberto has 29 years of professional experience in real estate and 12 years at JPMorgan, where he oversees portfolio management and research teams. Previously, he has worked at Lehman Brothers, Salomon Brothers and Aetna. He holds an undergraduate degree from Harvard, a master’s in business economics from the University of Hartford and a Ph.D. in finance from the University of Washington. Additionally, he was a professor of real estate and urban land economics at Southern Methodist University. He has published extensively on real estate finance topics and serves on the editorial boards of several journals. He is past president of the Real Estate Research Institute and a past director of the Pension Real Estate Association (PREA). As co-creator of the Giliberto-Levy Commercial Mortgage Performance Index and winner of PREA’s Graaskamp Award for research excellence, he recently helped launch RED-SIG, the U.S. real estate derivatives special interest group.

It was only a matter of time before there was demand for ways to hedge exposure. With risk-averse institutional investors allocating more to real estate in recent years, enter real estate derivatives—index futures and swaps. These are prime tools for risk management in other sectors of the economy. Well-established in the United Kingdom, real estate derivatives are relatively new to the United States, but have the potential to markedly change the way most U.S. real estate portfolios are constructed and managed.

Portfolio recently sat down with Michael Giliberto, senior portfolio manager for real estate at JPMorgan Asset Management, to see what the practitioner experience has been thus far and what effects these new instruments might have on U.S. REIT investing.

Portfolio: Real estate derivatives are a relatively new concept in the United States. Can you explain some of the basics?

Giliberto: Hedging is the most basic use of derivatives, and it can be very useful in the United States.

It's been hard for real estate owners to short direct real estate, and that's what you need for hedging. In theory, you can hedge a real estate portfolio by selling exchange-traded index futures. If real estate values drop, you gain on your futures contracts. However, if real estate values go up, you lose on futures but, of course, your real estate is more valuable. You could say this hedge is like an insurance policy: you pay some amount to protect against a substantial loss.

Some investors are using over-the-counter index return swaps to secure unrealized gains, a form of risk management. Suppose you bought properties or REIT shares at 50 and your portfolio is now worth 100. You may be worried the market value will go soft in the short run, but you don't want to sell the assets. Then you should agree to pay a real estate index return in exchange for receiving a cash return, either a fixed rate or floating rate, from the counterparty taking the opposite side of the swap.

Portfolio: Aside from hedging, what are some of the other uses for real estate derivatives?

Giliberto: We also envision using these instruments for price discovery, to provide exposure to real estate while assembling a direct portfolio, to rebalance portfolios and to enhance returns. In addition to derivatives on publicly traded instruments—those based on REITs and commercial mortgage-backed securities—there also are derivatives connected to private real estate market indexes, such as the NCREIF Property Index (NPI).

There's a lot of interest in NPI-based derivatives for price discovery in the private market, but there is much less notional value outstanding in the United States than in the United Kingdom, which has had an active, index-linked derivatives market for several years. In the United States, there aren't many actual trades, but we are starting to see daily quotes. People are trying to get some indication of where the index might be headed, since the private-market index itself is a bit slow to react to market events.

There's no track record yet showing whether derivatives are a great or horrible predictor of future property values. However, we've seen people using the derivatives on the IPD index of private-market real estate in the United Kingdom to get advance warning of property price declines. Not that people base their portfolio decisions entirely on that, but it does give them another data point.

Portfolio: How can these instruments rebalance portfolios?

Giliberto: For example, say you have a portfolio that has a strategic asset allocation of 50 percent retail and 50 percent office, and your retail has done well and now exceeds 50 percent of total holdings. You will want to increase the weighting of office and decrease retail to bring the portfolio back in line with its strategic targets. It takes months to sell buildings and cost effectively moving a big block of stock could take several days or weeks.

However, by adding an "overlay" of derivatives, you can implement your plan today—paying the return on a retail index and receiving returns on office—while you're waiting to execute the trade in the cash or direct market. You can use the same mechanics to gain exposure to real estate or other various segments. You can also enhance returns where you already have holdings by going long in the underlying and long in the derivative. This increases your winnings if your insight proves correct.

However, in all these cases, the great thing about derivatives is that you can act on your insight right away at low cost.

Portfolio: Real estate swaps are a possible alternative to ETFs. Are these derivatives a threat to traditional REIT investing? Are you seeing people choose one over the other?

Giliberto: No. It's self-limiting. If the underlying investments ceased to trade, the derivative would cease to exist. Additionally, if I'm an investment bank trader selling you a long position in a REIT stock index, I'm probably going to transact in the constituent stocks to create a hedge on my trading desk.

Derivatives may shift where trading occurs, from clients' hands to a different part of the chain, but it won't shrink volume. Derivatives haven't done anything to tap down volume in other equities, fixed income or currencies. If anything, they probably have increased trading activity in the underlying assets in those classes.

Portfolio: Are derivatives bringing new investors into real estate?

Giliberto: We will see that over time. We're in the very early stages. We're starting to get some inquiries from non-U.S. institutional investors who are wondering whether this might be a more efficient way for them to get exposure to U.S. real estate than buying assets on their own. That part of the market has a lot of potential, but there are tax and accounting issues that still need to be worked out.

Portfolio: Are these derivatives beneficial in any other ways we haven't touched on yet?

Giliberto: In the 1980s, we had an investor-led building boom. Investors wanted real estate to diversify their portfolios, and money went into new construction, even though there weren't enough tenants to fill the buildings. Excessive capital inflows exacerbated cyclicality.

However, derivatives now allow investors to reap the return stream without having to put capital into the physical product. While this would not repeal the property cycle, it could potentially, on the margin, help reduce it. Through derivatives, we may end up with less volatility in the physical property, and that would be a good thing.

We've already been moving in that direction for the last 15 years or so through the growth of REITs and CMBS. Derivatives just move us a little further down that road. As a portfolio manager, I would love to see this market develop liquidity and depth, because it would give me a lot more tools to use.