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A property derivative is a specific type of financial instrument in which the value of the derivative fluctuates depending on changes in real estate assets. Contracts that cover such derivatives are usually written based on real estate property indices; well-constructed, broadly-based indices are vital to these types of financial transactions. These transactions are quite complex, so usually corporations or sophisticated investors are the ones using derivatives. Examples of property derivatives are forward contracts, total return swaps, or bonds with the derivative in the bond structure.
Forwards and future contracts are the most common transactions using property derivatives. In a typical future contract, an investor makes an agreement to pay a certain amount at a specific future time. Another investor will then pay a multiple of an agreed-on property index. This multiple is fixed. A simplistic way of looking at this is that each party is betting on a different future financial outcome.
Some commercial real estate investors use strategies such as swaps. These make payments based on an interest rate index. Property derivatives allow investors to be in the property market without having to actually buy and sell buildings. For this reason, another term for trading with property derivatives is synthetic real estate.
If the investor has rental property and a loan with payments that are fixed, variations in the amount of rent he can charge means he may not be able to cover these payments with the amount of income he takes in from the property. Using derivatives can help deal with this possibility; the investor can take advantage of the fluctuation in value of the building without having to sell it. Rental rates often go up and down with property values, so the derivatives may help provide additional income during times when the rent is low. The difficulty in this is in deciding exactly what derivative is best to use.
Essentially, financial transactions with property derivatives have two counterparties who exchange cash based on the value of an agreed upon index. It is recommended that real estate investors use only simple derivatives and those that are closely matched to the the physical properties involved, as investors who invest in complex derivatives run the risk of bankruptcy. If used cautiously, however, property derivatives may help stabilize commercial real estate and help protect against forced sales.
The United Kingdom has been a world leader in using property derivatives. The most common index used in the UK for commercial properties is the Invest Property Databank. This index also is used in several other countries including Australia, Germany, Switzerland, France, Italy, and Switzerland. It is important that indices used in derivative transactions be reliable. In the United States, the two most common indices used are the National Council of Real Estate Investment Fiduciaries Index and the Standard and Poor's Index.