This is the sixth in our series of articles of ways to invest in real estate.
In the previous installment, we reviewed how real estate index funds match up against REITs. Real estate indexes form the basis for other types of financial instruments besides mutual funds and exchange-traded funds. In the next three articles, we’ll discuss how real estate indexes underlie three derivative contracts: futures, options, and swaps.
Real Estate Indexes
There are many real estate indexes, but for illustrative purposes, we’ll concentrate on the Dow Jones U.S. Real Estate Index (DJUSRE). Recall from the previous article that the index sponsor sets the criteria for including constituents within the index. The index value is equal to the sum of the constituent values, usually on a weighted basis. For example, in a capitalization-weighted index, the value of each constituent is multiplied its market cap (i.e., the number of outstanding shares times the price per share).
Dow Jones U.S. Real Estate Index
The Dow Jones U.S. Real Estate Index is composed of U.S. REITs and other companies involved in real estate management, development or ownership. It is a float-adjusted, market-cap-weighted index. (Float adjusting excludes locked-in shares belonging to insiders, governments, promoters, etc.). The composition of an index and the weight of each constituent is periodically rebalanced, i.e., adjusted for changes in market cap, IPOs, mergers, takeovers, bankruptcy, and so forth. DJUSRE is rebalanced annually for market caps and three times a year for other adjustments.
As of April 30, 2019, DSJURE contained 114 constituents. The constituent with the largest index weight was American Tower Corp, an infrastructure REIT comprising 7.8% of the index’s total capitalization. The weight of the top 10 constituents was 37%.
The following is a quick review of futures contracts.
A futures contract is a standardized agreement to buy or sell a specified quantity and quality of the underlying commodity or instrument for delivery on a specified future date for a specified price. Real estate index futures are financially settled — they are purely financial transactions and do not involve physical delivery, just cash payment.
Buyers and Sellers
The buyer of a futures contract holds the long position. The buyer will take delivery of the underlying asset or cash based upon the price movement of the underlying. The buyer profits when the underlying asset gains value.
Conversely, the seller holds the short position, making delivery and profiting when the underlying asset loses value. Futures sellers are often hedgers who want to reduce their price risk for a related asset, such as the real estate market. For example, a large institution with a heavy investment in REITs or REIT funds might sell futures on the Dow Jones U.S. Real Estate Index to hedge against falling REIT prices.
In the United States, the futures trade on several exchanges, including the Chicago Mercantile Exchange (CME/GLOBEX), the Chicago Board of Trade (CBOT), the New York Mercantile Exchange (NYMEX) and the InterContinental Exchange (ICE). Dow Jones U.S. Real Estate Index futures trade on the CBOT. The Commodity Futures Trading Commission (CFTC) is responsible for regulating U.S. futures trading and sets rules to which the futures exchanges and traders must comply. Each futures exchange has a list of the particular futures that can be traded, along with a complete set of specifications for each contract. Exchanges ensure daily payments between buyers and sellers to reflect the change in the prices of the underlying commodity, in a process called marking-to-market.
The value of an index future is a multiple of the underlying index. For the Dow Jones U.S. Real Estate Index, the futures contract is priced at $100 times the index value. An index value of 340 would thus fix the price of the corresponding index futures contract at $34,000. A trader would take a position in the contract by opening a futures brokerage account, depositing the required initial cash margin into the account and then entering an order to buy or sell one or more contracts.
Marking to Market
When a contract is traded, both buyer and seller must post margin with the exchange of 3% to 10% of the contract value. This margin, which may need to be subsequently replenished, is used by the exchange when it marks contracts to market daily, that is, revalues contracts to reflect the current futures price of the underlying index. If the index has risen in value, the exchange moves cash from the seller’s margin account to that of the buyer. The reverse is true when the index value declines. If the contract hasn’t been closed out before the expiration date, the exchange makes the final cash transfer, based on the closing value of the underlying. Physical delivery, if necessary, must then occur by a specified date.
Margin and Marking to Market
Each futures contract requires a cash deposit, or margin, that ensures the trader can pay for any losses that occur during the trading day. At the end of the trading day, each account is marked-to-market: The value change in the contract is withdrawn from the loss party’s margin account and deposited in the gain party’s account. For example, if the underlying has risen in price, the exchange moves cash from the seller’s margin account to that of the buyer.
The reverse is true when the price declines, and the long position is the loss party. All parties must observe the futures exchange’s rules governing the minimum amount of margin maintained in the brokerage account. Failure to do so will result in a call for more margin and possible liquidation of the contracts held.
The margin to maintain a position in Dow Jones U.S. Real Estate Index futures is $1,300/contract. For example, if the day’s closing price of the futures contract increased by $200 relative to the previous close, the exchange would transfer $200 from the seller’s account to the buyer’s. If the cash in the seller’s account falls below $1,300/contract, the seller would have to replenish the minimum cash amount — the maintenance margin — or face a margin call. This applies equally to the buyer when prices fall. In this way, both the buyer and seller are kept up to date on their profits and losses.
The margin on Dow Jones U.S. Real Estate Index futures varies over time but is currently $1,300 per contract. Each one-point move in that index translates into a $100 change in the futures contract. Thus, if the index went from 340 to 350, the long futures position would earn $1,000 per contract. The percentage gain on the index is 2.9% (i.e., 10/340), but the percentage gain on the futures contract is 76.9% (i.e., $1,000/$1,300). This outsized gain is a result of the leverage obtained by depositing only a small portion of the index’s value into the margin account. Of course, a loss of equal magnitude is also quite possible — leverage magnifies risk as well as reward.
Expiration and Delivery
Futures contracts are highly standardized, and this includes standard expiration dates. When the contract expires, the buyer and seller receive their final mark to market. If the contract calls for physical settlement, the seller must deliver the underlying asset to the buyer at the specified location on the specified date. The Dow Jones U.S. Real Estate Index futures contract is financially settled, so no physical delivery occurs.
A trader can close out a futures position before the contract expires through a process called offset. For example, if the buyer holds three contracts, she can sell three contracts to offset her original position. The reverse holds true for the seller. If the contract hasn’t been closed out before the expiration date, the exchange makes the final cash transfer, based on the spot (immediate delivery) price of the underlying asset.
The Dow Jones U.S. Real Estate Index futures contract trades in a series of three-month intervals, with expiration dates in March, June, September, and December. Each series is uniquely named in the following pattern: RExnn where x designates the expiration month and nn designates the year.
Characteristics of Index Futures
The following table summarizes primary characteristics of index futures.
|Minimum investment||Medium. You must deposit margin for each contract. Typical margin amounts are in the hundreds or thousands of dollars, ranging from 3% to 10% of contract value.|
|Liquidity||High. Index futures are publicly traded on exchanges that provide instant liquidity.|
|Control||Low. You control what investments to make, but have no control over the underlying index.|
|Diversification||High. An index futures contract covers the constituents of the index.|
|Leverage||High. Underlying REITs use debt for leverage, and the futures contract requires only a small margin deposit.|
Futures contracts are an efficient way to gain exposure to the underlying asset. Real estate index futures let traders and investors take a bullish or bearish position on the underlying real estate index, which is largely composed of REITs. The futures contracts have no purchase premium, are highly regulated, insured against default, highly diversified, highly liquid and highly leveraged. However, it can cost thousands of dollars to establish a position in index futures, much more than required for an index fund. The large amount of leverage provided by futures contract means that they are riskier than index funds, but also potentially offer higher returns.