Real estate is on the tip of most investors' tongues these days, followed by the words "sub-prime lending" and "U.S. economy." CME Group is aiming to address these issues and the $5.3 trillion U.S. commercial real estate market with its SPCREX Index futures contracts.

"We're looking at this product category in a very different way," says Felix Carabello, director of alternative investment products for CME Group. "If you look at the utility value, property has always been a tangible asset. But over the past several years, the property itself has become a wealth-producing asset class."

CME Group's 10 commercial real estate indexes were launched last September with five regional indexes, four by commercial property type and one national index. CME Group teamed up with Global Real Analytics (GRA) to create the new products, called SPCREX Index futures. Charles Schwab Investment Management, the asset management arm of Charles Schwab Corporation, acquired GRA in January 2007.

The indexes are produced by GRA and published by CME Group's longtime partner Standard & Poor's. GRA has been in the commercial real estate business as an asset manager and publisher of key commercial real estate data for about 25 years. The commercial real estate indexes are - pardon the pun - ground-breaking contracts, representing the first such derivatives ever.

Blueprints for CREX
GRA's index is compiled by collecting closed sale prices on commercial real estate, which includes office, retail, warehouse and apartments, and collectively makes up the bulk of the commercial real estate activity in the United States. The CME Group contracts are cash settled and will be offered by those four market sectors as well as by region - Northeast, Midwest, Mid-Atlantic South, Pacific West and Desert Mountain West, plus a national index.

Updated monthly by GRA, the index numbers are based on a three-month rolling average transaction price per square foot, calculated using the broad-based target market geographic definitions, refined property type definitions and commercial stock weights. In other words, the contract will look a lot like a stock index futures with a multiplier. For example, if the March 2006 National CREX is at 125.00, with a $500 multiplier, the futures contract will be valued at $62,500.

Robert Edelstein, who consults with GRA, says the index is unlike any other commercial real estate index.

"The key is that we use current prices from transactions," says Edelstein, who also serves as Haas Real Estate Group co-chair at the Fisher Center for Real Estate and Urban Economics at University of California, Berkeley. "Many other real estate indices, by comparison, use other techniques such as appraisals and repeat sales. We are looking at about 60,000 real estate transactions per year, processing them, verifying them and making sure there are no duplicates, and separating them by building quality. So it becomes very refined."

The new contracts complement CME Group housing futures, launched last May and based on the Case-Shiller Home Price Indices. Unlike CREX indexes, Case-Shiller calculates price changes of individual single-family residences over time and reflects price changes that may have sold more than once.

Who's moving in?
The contracts have a potentially diverse user base, from hedge funds wanting to expand into another asset class, to pension funds looking to hedge exposure to their commercial real estate holdings in the United States. Smaller equity real estate funds, larger portfolio managers, developers and Real Estate Investment Trusts (REITs) are natural hedgers of the SPCREX Index contracts. Other players include foreign real estate investment firms looking for exposure to the U.S. market without actually having to own U.S. properties.

"They could use the contracts obviously for hedging purposes by figuring out their value at risk and applying the insurance," says Larry Souza, managing director - index services, Charles Schwab Investment Management. "From a portfolio allocation standpoint, funds and investors could apply a certain percentage into the contracts while firms are searching for and purchasing commercial properties in, say, the northeast. They can then unwind those positions as the actual real estate purchases are made in a given region."

CME Group and GRA executives believe the contracts will take some time to gain volume and trading momentum. But planners believe this is a good time to launch such a contract, just as banks and institutions have built a sizeable market for securitized products, now topping $1 trillion.

Over the past 10 years, for example, the REITs market jumped from $58 billion in 1995 to $400 billion in 2007. Commercial mortgage-backed securities have grown from $20 billion in 1995 to $170 billion in 2007. It is then estimated that if commercial real estate synthetics make up just 1 percent of the total direct commercial real estate market, the potential market cap for tradable commercial real estate index futures and options could jump to $53 billion over the next three to five years.

And then there are the banks and mortgage companies caught up in a difficult market. CME Group is now examining just how its commercial real estate contracts can fit into this new mortgage lending and real estate environment, especially given the sub-prime lending problems that have hit banks and mortgage lenders hard in recent months.

"We're in a position to offer something of value to the marketplace," Carabello says. "But in order for us to do that, we have to think outside of our traditional way of doing things."

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