duETS Product Invites New Players to Real Estate Field
- Aug 02, 2017
As the question of where we are in the real estate cycle looms, industry participants who are either bullish or nervous about the state of the market now have a way to place their bets. Index veteran Kelly Haughton, who created the Russell index family while at Russell Investments and is now the CEO of financial services firm Global Index Group, realized the largest asset class out there did not have a successful index tool, leading him to launch the Down/Up Equity Trust Securities (duETS) synthetic investment product in March. Tied to the performance of the NCREIF Index, duETS allows investors to short or long the private real estate market, without investing in actual properties. CBRE Capital Advisors will sell the product. In an interview with Commercial Property Executive, Haughton discusses the unique benefits of the duETS product and why he believes it will bring new investors to the real estate industry.
CPE: What was behind your decision to create this new product for investing in commercial real estate?
Haughton: The investment community as a whole has designed and built many useful tools based on indexes for stocks and bonds. We realized the largest asset class out there that had no real successful index tools was real estate. We believe bringing the thought process of indexes to the real estate community can really benefit the asset class by improving the set of tools available to people who are investing in, holding and managing portfolios of real estate. I’m a longtime index veteran, so I think in terms of index technology. Real estate is sort of the last frontier, so we’re excited to develop this product.
CPE: What is unique about this product?
Haughton: We specifically designed duETS to work with private real estate indexes. DuETS are synthetic, tradable securities tied to the performance of the NCREIF Property Index (NPI). They allow investors to participate in the performance of private commercial real estate synthetically, without purchasing or selling actual properties. Because the structure does not rely on baskets, it makes the product unique in that it’s both an index-related product and one that’s specifically designed for real estate.
The initial duETS are now available for purchase from CBRE Capital Advisors.
CPE: Could you explain why you created Ups and Downs components of the duETS product?
Haughton: We’ve ended up with our Ups and Downs because investors needed a financial product that would let them efficiently hedge their portfolios (Downs) and there are certain instances, like portfolio rebalancing, that become a lot easier with Ups. In a lot of other index-related investment products, you need an underlying basket of securities or assets to be able to invest. But with real estate, you can’t do that. For example, there are more than 100,000 properties in the U.S. commercial property market; you’re not going to buy a little piece of each one of them.
Because of that lack of feasibility, we had to create another kind of instrument that would let them invest on the future performance of the index and get similar returns. Another change we made was in the area of counterparty risk. In the swap world, for example, you run into some risks because you’re relying on the other side of the deal to come through. We saw in the financial crisis that those kinds of promissory notes can be problematic. For our securities, everybody pays a positive price; the money is set aside in a trust and invested in Treasuries. BNY Mellon is the custodian and the funds are in a separate trust account, so it’s not on their balance sheet. All of that makes it much safer than a swap.
CPE: Why would one choose Ups versus Downs securities?
Haughton: Downs would, broadly speaking, be for anybody who finances or owns commercial real estate, either directly or through a fund, and would like to hedge it. Real estate financing players are one group that is very interested. With our initial product that is based on a commercial property index, we have people who have commercial mortgages in their portfolio that want to hedge against the possibility of a downturn in commercial real estate. There are also investors who own the underlying real estate and are nervous, so they want to hedge against their portfolios. There are also investors, like hedge funds, who just like to short, and there really hasn’t been a way to do that.
Ups are securities for people who would like to experience real estate-like returns in a cost-effective way. Our securities can be bought and sold any day, so you can make trades more rapidly than you could in buying actual buildings. Because it’s a standardized security, there’s going to be more trading than there would be in an individual building. People who are bullish on the real estate market are more likely to buy Ups and people who are nervous are more likely to buy Downs.
CPE: What advantages do duETS provide to U.S. versus foreign investors?
Haughton: Because our securities are legally equity securities, they are taxed as if they are equities. This is of particular importance to foreign investors who’d like to get U.S. exposure and would otherwise be subject to FIRPTA. FIRPTA taxes are typically much higher than the tax on equities, so there is a tax advantage in buying Ups versus buying actual properties.
The lack of counterparty risk is a big deal for domestic investors. One way to think of securities is as fully collateralized, because when people buy the Ups or Downs, the cash goes into a trust and there’s a pool of money there and you’re entitled to a portion of that pool of assets at the end of the period. Because there is that pool of assets waiting to be divided up, it’s safe. You don’t have to worry about whether or not somebody’s going to come through because the money is already set aside.
CPE: What are the investor requirements to use the duETS product?
If you’re a U.S.-domiciled investor, you must be what’s known as a Qualified Institutional Buyer (QIB), which means you need $100 million of assets that you are the fiduciary for or more, so the current product is basically for institutions. For foreign investors, though, the SEC doesn’t have the same requirements, so any foreign domicile, institution or even a person can invest in duETS.
CPE: What has been the response to the product so far and what types of investors have already expressed interest?
Haughton: We’ve had interest from a variety of prospects: banks, hedge funds, pension funds, insurance companies and foreign investors. Within the hedge fund space, a lot of the interest has come from mortgage hedge funds or distressed debt hedge funds. There’s also been interest from the global macro funds that make bets wherever they can and now they have a set of tools that allow them to more easily make bets in real estate.
The people most interested have been those that are accustomed to dealing with securities or pieces of paper, as opposed to bricks and sticks. So a lot of the interest is from the financial institutions. I think people who are operating real estate should want to use this as another tool in addition to leverage tools and joint ventures, but they are not used to this kind of thing so they’ve been less interested than we would hope for. However, we believe in the long run these are useful tools for those folks and we will see some interest.
CPE: Are there any challenges you foresee with this new investment product?
Haughton: Any time you’re trying to do something different or new, there’s a big educational component to what you’re doing. We have to talk to people a lot of times, and we’re doing that every day. CBRE Capital Advisors is also working on that. I think it’s going to take some time, but we’ve been very pleased at the reaction from many parts of the industry. They believe we need these kinds of instruments for real estate because we need a wider array of portfolio and risk management tools than we have today. DuETS are definitely aimed at providing that wider array.
CPE: When is the expected launch of the product and what size of the market do you expect the product to reach?
The first series of commercial duETS has launched, and you can buy them today. We’re working on lining up investors right now and we’re hoping to have our first transaction by the end of September. But these duETS are open-ended products, so even if we get up and going by September, you can still come in later, too.
It’s difficult to predict what size market it will reach, but it could be many billions of dollars if banks look at duETS as a way to both hedge their portfolios and as part of their tier 2 or tier 3 capital for their capital requirements under the Basel Accords. If foreign investors find duETS to be a tax-efficient way to invest in U.S. real estate, that could be many billions of dollars. If real estate securities investment managers and mortgage and distressed debt hedge funds decide duETS are another tool in their arsenal, those could be big markets for us.
CPE: Can you provide more details on the development of your newest product, duETS U.S. Housing 2x?
We’ve always wanted a product structure that was flexible. It’s easy for us to change the index on which duETS are based, to change the multiplier or to change the measurement period. We always wanted to be able to do a housing product. In the housing arena there’s probably as much if not more need for duETS as there is in commercial property. Fifty to 60 percent of the people we talk to about the duETS commercial property product ask, “Well, are you going to do a housing product?”
We see a lot of interest, and the classic case for the Downs is the residential mortgage market is much larger than the commercial mortgage market. There are trillions of dollars of residential mortgages and securities out there that could potentially be hedged. The initial housing product will be an institutional product just like the commercial property one. Both products are being filed with the SEC so there can be broader distribution, but that’s at least a year away.
CPE: What are some of your other goals for duETS?
Haughton: Our focus is on successful launches of the duETS commercial property and duETS housing products. A couple of elements will be ongoing activities for us. We’re going to continue to work to educate investors about the nature and benefits of duETS, and the second part is working on recruiting more market makers and brokers to help investors purchase duETS.
We believe these are important products in terms of improving people’s ability to manage their portfolios. I think Robert Schiller’s point that, to some extent, housing bubbles and real estate bubbles are more likely when you don’t have the ability to hedge or short the market, is correct. One of the important functions of duETS is the ability to hedge in the event of the next financial crisis. Schiller made the point that having an effective tool will reduce the size of the bubbles and reduce the frequency. We’ve been inspired by his comments, not the least because we agree with them, so I think that makes this an important product that’s coming out in this space.