Journal of Real Estate FinaDce and EcoDomics, 11: 219-233 (1995)

© 1993 Kluwer Academic PubUshers

Risk Management of Real Estate:

The Case of Real Estate Swaps
TAEH. RMIK
Oiicago Board of Thade, Chicago, IL 60604 and FaaiUy of Commerce and Administration. Concordia
University, Montreed. Qu^>ec H3G 1M8

LORNE N.
Ibaitty of Commerce and Admuustration, Concordia University. Montreal, Quebec H3G IMS

Abstract

Real estate swaps arc a recent financial innovation based upcm tbe principle of con^taiative advantage. A real
estate swap is a useful tool for real estate risk management and for participating in real estate im'estment witbout
tbe bigh coste associated witb real estate. Potential economic benefits and costs associated with real estate swaps
arc considered and real estate swaps are compared lo alternative tools for real estate risk management. Tbe ex-
pected utility and effectiveness of risk management witb a swap in a multiperiod framenork are analyzed. The
analysis finds that the subjea property's return and its risk characteristics (as reflected in its correlation with
interest rate and property index returns) delimit tbe risk management potential of a given swap position. Optimal
swap positions are sbown for various r^ons and property types based on bistorical return series,fromtbe period
between 1983 and 1992, and tbe parameters of tbe dynamic model develc^>ed.

I&rs Wbrds: real estate swap, real estate risk management

A real estate swap is an agreement between two parties to exchange a series of p^ments
without exchanging the underlying real estate. The term real estate jwop has sometimes
been used to describe another type of transaction involving real estate: exchange of owner-
ship of one piece of real estate for another. Such confusion on the terminology is due to
the nascent state of real estate swaps.' The term swap should be reserved for a transaction
that involves an exchange of payments with fixed ownership claims.
Figure 1 illustrates a typical real estate swap transaction. A real estate owner promises
to p ^ the opposite party at designated intervals a payment on the notional principal calcu-
lated at a rate of return linked to a real estate index such as FRC-NCREIF Property Index.
The opposite party, an institutional investor or a bank, promises to pay to the real estate
owner at the same intervals a fixed or floating amount of interest on the notional principal.
In the example, we have assumed a swap based on the LIBOR. In interest rate swaps and
currency swaps, participants swap their liabilities with their counterparts. In real estate
swaps, however, participants swap income streams.
In this paper, we provide an analysis of real estate swaps. In the next section, we outline
the basic rational for such swaps, and discuss their relative advantages compared to other
instruments for real estate investment and risk management. In Section 2, we develop a
multiperiod stochastic model for assessing the benefits of real estate swaps and derive rela-
tionships for determining the viability of such swaps as well as their optimal size based
220 R\RK AND swrrzER

Real Estate Index

Spread
Institutional
Investor

Esmings from
Real Estate

Real estate swap using financial intermediary will have a financial intennediary in between the two parties. The
p^nnent of floating interest rate by tbe institutional investor could be financed by lending floating-rale loans if
the investor does not have internal source of investment whose Ktmn is tided to floating interest nite.

Figure I. Real estate swap.

on a property's return characteristics. In Section 3, we apply the model to historical real

estate return series that we construct (adjusting for smoothing biases) from different regions
and property types in the United States for 1983 to 1992. Overall conclusions are provided
in Section 4.

1. The Rationale for Real Estate Swaps

The standard rationale for real estate swaps hinges on the economic principle of compara-
tive advantage. Since the patterns of real estate returns and interest rates are quite different,
one party ma^ have a comparative advantage over another in generatii^ a particular stream
of returns. Further savings from the enhanced liquidity ofthe market may also be e7^>ected.
A real estate swap permits both parties to exploit their comparative advantages and produce
savings. As is shown in the recent literature of interest rate swaps (T\imbuU, 1987; Smith,
Smithson, and Vftikeman, 1988; V^ll and Pringle, 1988), such benefits are not obtainable
in a complete, integrated capital market. These studies show that market incompleteness or
agency costs m ^ provide an alternative explanation for the continued growth of the swap
market. Since high management and information costs characterize the real estate market,
agency costs are expected to be a significant stimulus to the development of swaps.^
In addition to the joint savings associated with swaps, real estate swaps provide a vehicle
for diversification of the investor's portfolio. Several studies (Folger, 1984; Webb and
Ruebens, 1987; Firstenberg, Ross, and Zisler, 1988; Giliberto, 1993, and others) have gen-
erally concluded that real estate holdings of 20 percent would benefit the typical pension
fund by improving diversification and thereby increasii^ return per unit of risk incurred.
Real estate swaps may entail hidden costs, however. Real estate owners have an option
to develop or sell whenever it is optimal (Titman, 1985; Capozza and Helsley, 1989). A
proper^ with such development/put option features should be more valuable than a claim
to the cash flows from the property for a fixed period of time. An analogy can be found in
the timing option of futures contracts (Cornell and French, 1983), where futures contracts
are less valuable than an equivalent portfolio of the underlying asset and bond, since the
REAL ESTATE SWAPS 221

owner of the underlying asset has the option to defer any capital gains taxes while the long
side of the corresponding futures contract does not. Property values include the values
of such options and the rate of return fTom the FRC-NCREIF Property Index should reflect
any change in the option values. However, the investor in a real estate swap is unable to
exercise these options and thus does not benefit from the value of ownership during the
duration of the sw^.
The default risk of real estate swaps depends on the difference between the cash flows
at each payment period rather than on the level of cash flows, for the principals are not
exchanged. A real estate owner may have an incentive to de&ult if the owner perceives
the future returns on real estate to be higher than floating interest rate to be received, other-
wise the institutional investor m ^ have an incentive to default. In reality, however, use
of collaterals and the reputation e f ^ t s associated with de&ult should limit its occurrence.
Actual de&ult requires that both the contract value be negative and the contract owner be
in bankruptcy.'
A real estate swap could be used either to speculate on or to hedge against changes in
real estate values. Clearly, the risk of de&ult on the contract is influenced by its use. If
an institutional investor's cash flows are sensitive to interest rates and less sensitive to real
estate returns, the investor can realize both hedging and diversification benefits from the
swap. Thus, the probability of financial distress and bankruptcy is reduced. In contrast,
if a swap is used to speculate in the real estate market, the probability of bankruptcy would
be higher when the firm is in financial distress. As discussed above, the de&ult risk of
real estate swaps can be further reduced because the swap transactions are, unlike interest
rate swaps, exchanges of income streams. Thus, unless a swap is severely mispriced, default
risk will depend only on bankruptcy of either party.
Finally the use of real estate indices in determining the swap p^ments ma^ result in
basis risk when the underlying property's value does not move coherently with the indices.*
The returns from an appraisal-based index tend to lag behind the current market values.
It is a general presumption that the closer the property's return follows the index return,
the more beneficial the swap is to the real estate owner. However, as Section 2 shows, the
benefits from the swap also depend on the property return's volatility and its correlation
with the interest rate.
There are alternative institutional innovations, predating swaps, that allow individuals
and finns to invest in a broad portfolio of real estate and hedge the risk of real estate. Real
estate investment company shares or real estate investment trusts (REn^) allow individuals
and institutions to invest in a broad portfolio of real estate. They thus provide some benefits
(^portfolio diversification. The shortcomings of real estate investment companies and RETI^
as a hedging or diversification medium are 1) constraints on short sales, 2) leverage effects
(since most are equity claims on the underlying real estate portfolios), 3) their minuscule
representation (in market value terms) in the entire real estate market, 4) the high correla-
tion of their share value with the prices of shares in the stock market. The high correlation
between stocks and REI'R, around 0.79 during the last half of the 1980s is a consequence
of three &ctors—1) common influences on their capitalization rates, 2) common infiuences
on their prospects for future cash fiows, and 3) substantial real estate holdings among the
assets of corporations. In addition, the closed-end status of RETft make them resemble
closed-end mutual funds tluu are subject to discounts and premia in values that are unrelated
to the movement in the value of underlying securities.
222 [ARK AND swrrzER

Real estate insurance can be an alternative to hedge against adverse movements in real
estate values. Although real estate insurance is widely available to any real estate owner
who is intraested in hedging exposure to a marl^ downmm, die insurance premium presents
a tradeoffof return for reduced risk. In addition, real estate insurance cannot provide diver-
sification to an investor unless the investor himself sells the insurance. Writing insurance,
or writing put options, can be feasible only for highly diversified and well-capitalized
institutions.

2. Real Estate R i ^ Management with Real Estate Swaps

Tb compare the risk-return tradeoff from a multiperiod swap transaction, we develop a

model to capture the changing payoffe from the swap in various scenarios. The valuation
model of real estate swaps used here is based on the extensive Uterature on the valuation
of interest rate and currency swaps (Sundaiesan, 1991, and Cooper and MeUo, 1991). Sup-
pose that it is now time zero and that under the terms of a s w ^ . at each designated p ^ -
ment period, a financial institution or an investor receives pi^micnts tied to real estate returns
and makes floating interest rate payments. The reset dates and payment dates are assumed
to be the same. I^yment at each period depends on the rate of return realized from the
previous pigment period to the current payment period. De&ult risk is assumed to be neg-
ligible as discussed previously and is ignored for simplicity.

2.1. Cash Flaws ofa Real Estate Sw(^ Portfolio

Let us assume a real estate owner who holds a portfolio of properties and chooses to par-
ticipate in a SWE^) for T periods in order to hedge against unanticipated changes in real
estate values in Ihe future. In the beginning, time 0, the value of the properties is defined
as PQ. In the nott period, time 1, its value is expected to the E(P{) corresponding to an
rapected rate of return of E(ri). Likewise, the property index to which the swap payment
is going to be tied will ratperience an expected rate of return, E{R{) over the same period.*
The cash flows that the real estate owner with a swap receives in the next period can be
written as

CF{\) == q P i + Qil - R, - s), (1)

where Cj is the total yield of the property for the first period and accounts for both income
and capital gains. Q is die principal amount of the swap on which the interest and real
estate payments are based and s is the spread the s w ^ participant has to pay to the inter-
mediary. The swap spread can be regarded as a transactions cost that is proportional to
the principal amount, Q, and is dependent upon the d ^ u l t risk of the swap participant.
The swap spread is assumed to be set in the beginning and remains constant during the
life of the swap.
In a multiperiod setting, the cash flows for each period depend on the yield of the property
as well as the interest rate and real estate index returns. The cash flow from the property
REAL ESTATE SWAPS 223

changes as tbe yield and tbe property value change. If we assume a constant yield over
time,' c, = c, for r = 1, 2, . . . r, tbe cash flow at period t(\ ^ t ^ T) can be written as

CFit) = cP, + Qil ~ R,-s)

+Fi-\-r2-i'...+r,)+qiJ,-R,' s)], (2)

wbere q has replaced Q/PQ to note for tbe proportional amount of swap witb respect to
tbe initial property value.

2.2. The Real Estate Owner's Utility and the Optimal Amount ofa Real Estate Swap

To compute tbe risk of a real estate swap portfolio, we need to make furtber assumptions
on tbe bebavior of real estate returns and the interest rate. Tbe stocbastic processes of real
estate returns and tbe interest rate we use can be written as

dr = fiiir, t)dt + oiir, t)dzi

dR = fi2iR, t)dt + OiiR, t)dz2

dx = ti^ii, t)dt + ffjCi, /)dz3, (3)

wbere /xy, j ~ ^ R^ U are tbe mean drifts of tbe cbanges in tbe respective rates, and Oj,
j = r, R, i, are tbe instantaneous volatilities in tbe respective rates. Tbe Wiener processes
dzj,j = 1,2, 3, bave correlations pjjt. y. * = 1, 2, 3,j ^ k, respectively. For expositional
purpose, we noake tbe following cbaracterizations of tbe above processes wbere tbe drifts
and volatilities are constant:

liiir, t) = pLr, ai(r, t) = Or

) = Hi, a^ii, t) = ff,-. (3')

Tbese cbaracterizations give first-order autoregressive time series of eacb rate. For tiie real
estate renims (r and R), zero mean drifts (Mr = MJ? = 0) inq)ly lognormal distributions for
tbe property values. Tbe actual processes tbat tbese rates follow are probably more complex
but incorporation of more complex models does not alter tbe results of tbefollowinganalysis
and bence we proceed witb tbis approacb for heuristic purposes.' Tbis characterization
is valid only witbin a sbort time span (sbort-tenn swap). For longer-tenn swaps, tbe mean
drifts and instantaneous volatilities bave to be adjusted for tbe longer borizon.
Based on tbe above stocbastic processes, we can detennine tbe conditional expectations
and variances of tbe swap portfolio at any time in tbe future. If the lagged returns fiom
224 PARK AND swrrzER

the property, rj,j= 1, 2, ..., t ~ 1, are assumed to have negligibly low correlations
with I, and R,, then the conditional expectation and variance of f-period cash flow from
the swap portfolio can be approximated as (see Appendix A):

£[CF(Ol*o] + + 1)) + q{io - fig + - s)]

-2j + 1) + +

(4)

where *o is the infonnation set at time 0 (i.e., the current real estate returns and interest
rate), a^j is the conditional covariance ofy and k at time t given the information set ^Q. If
the real estate owner has a mean-variance expected utility function, the utility from a swap
transaction depends on the weighted sum of the expected cash flows and their variances:'

(5)
(-1

where Wj is the weight given to ttie f-period utility and can be considered a discount fector.
Equation 5 results from the assumption of additive and separable utility from each period
as previously used in multiperiod asset pricing models (Fama, 1970; Merton, 1973, and
others).
The real estate owner can determine the optimal quantity of a swap by maximizing (5)
with respect to q\

^ E*T1

+ f+ +
= 0. (6)

The second order condition is:

0. (7)

From (6), the optimal amount of the swap, 4, can be solved as

r
S **'(('o * ^ + '0*i - MR) - 5
q = '^ (8)
REAL ESTATE SWAPS 225

where the condidonal covariance terms are shown in Appendix A. The first term in tbe
numerator, IQ - R^ + t(^ - tiR) - s, is relatively small compared to the second term
for a larger PQ. Thus, for a positive optimal q to exist, provided that the second-order con-
dition is satisfied, a^^ should be less than O^R^ (the property return moves more in tandem
with the property index returns than with the interest rate), which is not an unreasonable
assumption.
Figure 2 shows optimal swap amounts for a property with an underlying value, PQ, of
$1 million for a contract length of 5 years (20 quarters). The real estate owner is assumed
to have a degree of relative risk aversion X = 4.'° The weight assigned to the expected
utility of each period (quarter) is assumed to be 1/0 + t) for period r." The swap amounts
are plotted with respect to different p^. Initial conditions for the rates are set for the cur-
rent market conditions such that the (quarterly) property return is 1% and the index return
is 2%. The index return is higher than the property return since the property return ac-
counts for capital gains only, but both have the same drift codficients. The interest rate
has a lower initial value than the indwc return and a lower but positive drift coefficient
(the case of an upward sloping yield curve).
The correlation between the property return and the index return, p^j?* is chosen to be
0.7 and the correlation between the index return and interest rate, py^, is 0.6. These num-
bers are based on actual correlations discussed in the nott section. As the first plot shows,
the optimal swap amount is not highly sensitive to the choice of a drift coefficients of the
property returns. The change of ±0.2 % per quarter is approximately 1% change per year.
With these changes, the optimal swap amount hovers around 3% of the property value.
The optimal swap amount is more sensitive to the standard deviation ofthe property returns.
As the standard deviation increases, the optimal swap amount increases as the real estate
owner finds it more beneficial to reduce imcertainty through the swap.
Differentiating (8) with respect to the correlation measures we obtain
T

dq (-1

t=\

bq ^

(-1

From the second-order condition for the optimal q, the denominator terms in (9) must be
positive. Therefore, the optimal q declines with higher correlation between the property
return and interest rate, p^, and increases with higher correlation between the property
return and the index return, pru- Intuitively, because of portfolio diversification/cross-
hedging effects, risk management with swaps is more effective and requires smaller swap
226 RMIK AND SWrrZER

Different Drifts

0.17%
0.03%
0.23%

0 0.1 0.2 a3 0.4 0.5 0.6 0.7

correlabon (r,^

Different Standard Deviations (irj

0.1 0.2 a3 0.4 0.6 0.6 0.7

correlacion (r,0

Initial Condition

Po - $1 million, s = 0.1%. X = 4. c = 2%, w, = 1/(1 + t), life = 3 years

r© = 1% Ro=-2% io = 1.5%
^, - 0.03% fig = 0.03% M, - 0.02% p,g = 0.7
e, « 4% ox = 2% ", - 0.5% Put = 0.6

Figun 2. Optimal swap position, q, (proportional to PQ) witb respea lo p^.

REAL ESTATE SWAPS 227

positions when the cash inflows (outflows) generated at each payment date move more (less)
in tandem with the returns to the underlying property. Even if we allow the swap spread,
s, to change based on the property's return characteristics, the above relations still hold
since Bs/Bpjr ^ 0 and ds/dprg £ 0 (see Appendix B).
In figure 2, as Pn approaches Pr« (0-7 in this case), the swap amount declines but remains
positive. This occurs because, for fixed correlations, when the interest rate has a lower
standard deviation than the property index return (which is the usual case), the covariance
between the property return and the interest rate will be less than the covariance between
the property reOim and the index return. The plots show that the optimal swap amount
depends primarily on the correlation between the subject property's return with the interest
rate. The future prospects of the subject property also influences the amount of the swap.
In particular, poorer prospects (with lower values for the drift coefficients coupled with
high uncertainty, measured by the standard deviation of their returns) require larger swap
amounts at the optimum.

3w Real Estate Swap Decisions Based on Resk»i and Property

The decision of the real estate owner to enter into a real estate swap depends on the return
and risk characteristics ofthe subject property. In this section, we examine these aspects
of property returns for different regiotis and property types and attempt to identify the p r ( ^
erties that are suited for real estate swaps. The FRC publishes a quarterly index of returns
for different regions and properties types. These returns can be used to construct return
series that fully reflect market values rather tban the appraised values that these indices
are based on. Fisher, Geltner, and W^bb (1994) unsmooth the ^ipraisal-based index returns
and construct a "Full-Information Value" index, using the bias correcting approaches that
have been recently developed (e.g., Geltner, 1991, 1993, and Ross and Zisler, 1991). In
this study, a similar method (explained in Appendix C) is implemented to construct un-
smoothed index returns for each region and property type. The resulting unsmoothed index
returns are assumed to represent the property returns in a swap, r, from each region and
property type. The constructed series provide the retuni and risk characteristics ofthe vari-
ous property types in each region and are used to assess the appropriateness of real estate
swaps for these properties.
Table I shows the unsmoothed index (quarterly) returns for each region and properly
type from 1983 to I992.'2 xhe national index return, both adjusted and unadjusted, has
been lower than the three-month LJBOR during the period. The severe recession in the
real estate market in the late 1980s and the early 1990s has caused the risk-return tradeoff
of real estate to deteriorate relative to investments in Eurodollars. For all region and prop-
erty types, the adjusted mean returns come close to the unadjusted mean returns, indicating
that appraisal returns are unbiased. However, the adjusted standard deviations are approx-
imately twice as large as their unadjusted counterparts. The correlations of the adjusted
return with the national index, R, and interest rate, /, show diverse variation across d i ^ r -
ent regions and property types.
These historical estimates of property returns, combined with the initial conditions used
in our dynamic model, allow us to estimate the optimal swap amounts (as a percentage
228 AND swrrzER

Vible 1. Mean return and risk of real estate (FRC-NCREIF Inda), and optiiiial swap positions q* Different
and property types (quaiterly returns, %; 1st quarter, 1983-3rd quarter, 1992).

Capital
Ibtal Return Appreciation Adjusted for Appraisal-Based Bias

a M 0 0 PrK 9(%)

3-M U B O R " 1.898 0.451

National Index 1.368 1.746 1.234 3.827
East
R&D 1.734 2.302 -0.155 2.329 -0.189 4.692 0.571 0.268 3.126
Office I.6S8 2.889 -0.008 2.935 -0.267 6.807 0.655 0.623 4.514
Retail 2.729 2.806 0.942 2.626 1.065 3.609 0.626 0.306 2.319
^Akrehouse 1.958 2.760 0.134 2.678 0.081 4.766 0.565 0.266 3.145
Midwest
R&D 1.205 1.900 -0.703 1.877 -0.802 2.879 0.587 0.250 1.978
Office 0.832 3.157 -0.886 3.154 -1.715 5.362 0.911 0.457 5.692
Re&il 2.339 1.541 0.448 1.465 0.490 2.357 0.404 0.403 0.908
^Abrctaouse 1.829 1.472 -0.084 1.418 -0.115 2.575 0.541 0.244 1.609
South
R&O 0.429 2.420 -1.321 2.413 -1.528 5.036 0.529 0.146 3.283
Office -0.861 2.825 -2.424 2.841 -2.825 4.336 0,635 0.388 3.085
Retail 1.784 2.158 0.116 2.085 0.122 2.669 0.687 0.449 2.010
V/anboosc 1.374 1.763 -0.537 1.710 -0.621 3.635 0.602 0.317 2.503
West
R&D 1.955 3.624 0.061 3.631 0.010 6.027 0.607 0.294 4.272
Office 0.513 1.997 -1.079 1.866 -1.306 3.170 0.763 0.384 2.791
Itetail 2.332 1.998 0.645 1.982 0.477 4.463 0.632 0.235 3.388
Wardiouse 2.005 2.116 0.358 1.640 0.084 4.208 0.566 0.276 2.761

*Tbe optimal q rqiresents the notional amount of the sw^i as a percentage of the underlying property value.
The initial conditions &om Figure 2 are used (with the exception of o^ p^, and p^).
**Adjuated from annual to quarterly returns.

of a hypothetical property value of $1 million) for each region and property type. Tkble 1
shows that swaps would be e^ctive risk management tools in all cases (the requirement
that q be positive is satisfied) for the period between 1983 and 1992. As shown in Figure 2,
the amount ofthe s w ^ is not highly sensitive to the drift coefGcients, and thus, the amounts
shown in Ikble 1 do not change much with different assumptions on the secular trend of
the property's returns. Among the various property types, office property in the Midwest
stands out as a property that requires the largest swap position, or equivalently could have
benefited the most from the swap. Office property in the East and R&D property in the
West also require relatively higher swap positions.

4. Conclusion

Real estate swaps are a very recent capital market innovation with the potential to become
a very popular and effective i^eal estate hedging and diversification instrument. Real estate
REAL ESTATE SWAPS 229

swap transactions can be justified on several grounds, including the simple economic prin-
ciple of comparative advantage. Real estate owners can use swaps to hedge their real estate
risk, while investors can reap the benefits of diversification from real estate investment
at reduced cost. We expect that in the next few years there will be increasing attention
devoted to the analytic valuation and economic analysis of real estate swaps.
Simple assumptions on the stochastic processes of real estate returns and interest rates
give rise to conditional expected cash flows and variances that are useful in assessing the
benefits from a swap. A real estate owner's expected utility from a real estate sws^p can be
calculated from the conditional values to obtain an optimal swap position for his property.
Our results also show that the subject property value's return and risk characteristics (as
reflected in its correlation with the interest rate and property index returns) delimit the
risk management potential of a given swap position.

Acknowledgments

The authors wish to thank Dennis Capozza. Paul Seguin, anonymous reviewers, and the
participants in workshop at Concordia University for help^l comments.

Appendix A

As the stochastic processes from (3) and (3') indicate, each rate of return follows a normal
distribution with a mean equal to a constant trend and a variance equal to its instantaneous
variance multiplied by the trend. Then, the conditional expectation and variance of each
rate is:

E[n\ro\ = To + urt, Var[r,\ro] = a}t

E[h\k\ - '0 + P-it, VariiMoi = afi. (A.I)

The covariance between these rates can be obtained by using the definition of conditional
covariance and Ito's lemma:

«^r«.i • Cov[r,, R,\rQ, R^] = {ji.R^ -t- ti^r^ + arOgPrR)t ~ ('"o +

Cov[i,, RflioRol = QiiRo + fifjio + (JiaKPiR)t ~ Oo + P-it)(R<3 + fiRt). (A.2)

When the rate r follows a Brownian Motion process with a drift as described in (3'),
the discrete ^)proximation of its process gives the following autoregressive model.

}) for I ^ j £ h.
230 PARK AND SWrrZER

Then, the conditional autocovariance of r can be sin^lified as

Cov[r-f> rikol = <^rS for 1 S 5 £ r. (A.3)

As stated in the text, the property rate of retom from each period does not contain infor-
mation on either the future real estate index return or the interest rate. Hence, the lagged
returns from the property are independent ofR and i. Consequently, the conditional covar-
iance of the lagged rates, rj, j = 1, 2, . . . , f - 1, with R, and i, are

,, Rt\rQ, /2ol = Covlr^, i,\rQ, IQ] = o(j), where \ £ s < t. (A.4)

(A.I), (A.2), (A.3), and (A.4) are applied to the cash flow (2) to arrive at its conditional
expectation and variance (4) given the current information set.

Appendix B

In an efficient swBp market, the swap spread should be greater with higher correlation
between the property value and the interest rate, of Bs/dpn ^ OL'^ An intuition behind this
relationship is that in a swap, the real estate ewner makes real estate payments and receives
interest p^ments from a variable rate loan. An owner with a property value that is highly
correlated with the interest rate (i.e., high p^) has a comparative advantage in issuing var-
iable rate debt. By agreeing to swap the property returns with interest rate, the owner loses
his advantage and as a result, his default risk, or swap spread, is greater. The swap spread
should be less with higher correlation between the interest rate and the index return,
ds/Bpijt ^ 0. The high correlation between the two underlying returns reduces the defeult
risk in a swap because the de&ult risk depends on the expected loss to the intermediary
and the expected loss depends on tbe di^erence between the real estate payment and the
interest payment.'* Naturally, the difference between the two payments will be smaller with
higher correlation between the two, and the expected loss, or the spread, is smaller as a
result. Finally, the spread should be less widi high^ correlation between the property return
and the index return (i.e,, ds/Bprn), since the correlation between the property return and
the property index return should have negative effect on the de&ult risk of the swap, or
the swap spread. The owner can also avoid the costs associated with cross hedging of real
estate when the property return is close to the indw return.

Appendix C

The FRC-NCREIF Index is based on appraised values of the underlying properties in the
index. The infrequent transactions (tf the underlying properties leave ^ipraisers little infor-
mation to work widi in determining maricet value at specific times. Thus, the quarterly
ai^raisers use the information from the most recent comparable sale with past appraised
values. This inches that the systonatic component to disaggregate level property values
will be smoothed over time in the appraised valuations. The underlying property values
REAL ESTATE SWAPS 231

are appraised at different points in time throughout each quarter, and the partial update
of the values results in further smoothing of the returns. The smoothing effects of the
appraisal-based index and the ways to correct them are thoroughly documented by Geltner
(1991. 1993). Ross and Zisler (1991), and Fisher et al. (1994). The following method of
unsmoothing the NCREIF index is based on both Ross and Zisler and Fisher et al.
The observed (smoothed) index return, r*, is assumed to depend on the unobservable
true (unsmoothed) returns from the current and the past periods.

ri = wor, + H'(B)r,_,, (C.I)

where r, is the corresponding true return during period t and WQ is the weight between
0 and 1, and w(B) is a polynomial fiinction in the lag operator, B:

w(B) = H-i + W2B + w^B^ + ... (C.2)

where B refers to one lag (Br,_i = r,_2), B^ refers to two lags (BV,_I = r,-^), and so
on. Equation (C.I) implies that the observed return can be represented by an autor^ressive
model of the form:

; ; i + e,, (C.3)

where (t>(B) is a lag operator similar to w(B) and e, is assumed to be WQF,. The above rep-
resentation provides an expression for the unobservable retum, r,, as a function of the pres-
ent and past values of the observable r*:

(C.4)

The standard deviations of the both sides give the following condition for WQ.

Wo = SD[r; - 4>(B)rU0VSD[r,] (C.5)

The unexpected movements in the real estate indexes must be related to the movements
in true returns. Thus, the standard deviation of the true retum, SD[r,], is assumed to de-
pend on the standard deviation of the residual error from the autoregressive model of the
observed returns (Ross and Zisler, 1991):

SD[r,] = ^ - 4 ^ o, + iVAR[r'] - VARU,])'"^, (C.6)

where e, = r" - ^ - * i ^ - i - The second term in the right side represents the portion
of the long-run volatility contributed by movements in the expected return. Only the first-
order autoregressive coefficient is considered in the calculation of the residual error, e,.
Likewise, in the calculation of (C.5), only the first-order coefficient is considered; 4>(B) =
^ j . (C.5) with (C.6) provides the nominal value of WQ, and from (C.4), a time series of
the true index retum can be constructed.
232 PASX AND SIWITZER

Notes

1. Sec, e.g., "Real-EstateSwaps CouldBeaMneHaPn^)«ty;'H6OSw«yoMmfl/,Dec^^ 1993. Accoid-

ing to tbe article, only a few have been consummattd. wbile others were i& the works. Tbe International
S w ^ E>ealers Association does not pi^lish aggr^ate data on real estate swaps as of this writing.
2. The passive institutional investor's source of relative comparative advantage may be in having greater access
to short'lerm funds, due to capital market iiqperfections.
3. Smith, Smithson, and ^A^eman (1986) suggest this requirement for de&iult and Hull (1989), Cooper and
Mello (1991) use this assumption to value de&ult risk of swaps.
4. Two real estate indices are ccnnmonly cited to represent tbc dianges in real e^ate value for the underlying
swsp. The most widely cited of thse is the FRC-NCREIF Property Index, which represents tbe property-
value-weighled returns of over 1800 unleveraged, diverse properties across the nation. An alternative national
index is the NARETT Equity Real Estate Investment Trust (RETT) Index, wbich is a market-value-wcighted
average of the returns of over 60 RETft (with more than 1000 properties in portfolios consisting of 75 per-
cent or more of equity interests). Since real estate swaps would typically involve commercial properties, the
index should iqjreseni the value of commercial properties. Currently, the FRC-NCREIF Property Index is
the only widely accqited index of commercial real estate values, and thus is expected to be the most common
type of index used in real estate swaps. Ib avoui basis risk from asset-mismatching, tiie real estate owner
in a swap should have a diversified portfolio of properties whose rate of return closely matches that of FRC-
NCREIF Property Index.
5. The iodex of return, R, is tbe total rate of retuni (» income plus capital appreciation), M^iiile the property's
rate of return, r, captures capital gains.
6. The interest rate is known ahead of the real estate rate of return each quarter since typically the interest pay-
ment is determined by the interest rate prevailing over each quarter. However, irt the multiperiod swap trans-
actioos. both tbe interest rate aod tbe real estate rate of return are to be realized in tbe future.
7. The constant yield assumption does not restrict the c ^ rate to be constant. It only assumes that the sum
of income and coital gains is a constant proportion (^ tbe property value.
8. The iiKerest rate piocess may bave a mean-reveiting drift and a volatility that dqwnds on the level of interest
rate as in Cox, IngersoU, and Ross (1983). Under such a model, tbe constant volatility term, Oj, in (3') can
be adjusted R) account for tbe current level of interest rate.
9. It is assumed that the real estate owner bas no otber assets in his portfolio or that bis wealth is concentrated
in real estate.
10. Tbis assumption on X is in line with most empirical studies in the litetature (Grossman and ShiUer, 1981.
and others).
11. The results are robust to different weight functions.
12. Although the total NCREIF index began in 1978, tbe region and type indices first became available in 1983.
13. Cooper and Mello (1991) analyze the de&ult risk of swaps and find that the swap spread is proportional
to the correlation between tbe value of the firm and the interest rate. In a real estate swap, it is reasonable
to assume tbat the value of the real estate is idoitical to the value of the firm, or tbe real estate owner.
14. This argument will bold only if tbe probability of bankruptcy hy tbe swap participant is independent of the
changes in interest rate, as was assumed by Hull (1989) and Sundaiesan (1991).

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