This is the eighth and last in our series of articles of ways to invest in real estate and focuses on real estate swaps.
Swap contracts come in a variety of types, including the total return swap, equity swap, contract for difference and credit default swap, among others. In this article, we’ll address the use of total return swaps to replicate the return one would earn on a REIT index ETF (exchange-traded fund). We choose this because it is a regulated, exchange-traded vehicle. Most swap contracts are over-the-counter (OTC) and beyond the scope of our current discussion.
Whether exchange traded or OTC, swaps can be used to gain exposure to a market without requiring an initial purchase of assets. Investors can use this exposure to hedge against risks associated with a position in the underlying asset (or similar asset), or to speculate on the change in value of the underlying asset. Swaps can also be used to execute an arbitrage (i.e., riskless) trade or to insure against a negative credit event (i.e., default, rating reduction, etc.) of a debt security. The canvass of swap trading is huge, and we encourage you to further research this interesting type of financial engineering.
Total Return Swaps
A total return swap (TRS) is a derivative contract in which counterparties exchange the returns on two different investments. In this discussion, we will focus on a TRS that exchanges the total return on a REIT index for the total return on short-term floating-rate debt. By total return, we mean interest, dividends, and price gains/losses.
Elements of a Total Return Swap
The elements of a total return swap include:
- Reference asset: The swap’s underlying asset or index, such as a REIT index.
- Swap counterparties: The two trading sides of a swap. In a TRS, the long counterparty (the “total return receiver”) replicates an exposure to buying the underling asset. The short counterparty (the “total return payer”) replicates the selling exposure. The receiver pays the income and gains from the specified fixed- or floating-rate debt to the payer. The payer pays the income and gains from the reference asset to the payer.
- Notional value: A number representing the value of the underlying asset. Neither party actually needs to hold the notional value. Rather, it is used only to calculate the required cash flows resulting from the hypothetical position’s total return.
- Term: The time until the swap terminates. Swaps can have any term, but most terminate within five years. Swaps often have provisions that allow a counterparty to request, for a fee, an early termination of the contract.
- Reset: A periodic exchange of the cash flows resulting from the swap counterparties’ notional positions. The reset is a mark-to-market that allows the counterparties to realize their gains and losses since the prior reset. Resets can occur with any frequency, but three months is a popular swap reset period.
- Netting: Instead of the two counterparties exchanging their full cash flows, the flows offset each other and only the resulting difference flows from loss counterparty to the gain counterparty.
- Off balance sheet: Swap contracts usually do not appear on the counterparties’ balance sheets except as a footnote. They are carried off the balance sheet because the counterparties do not own the underlying positions.
Real Estate Index
The reference asset for a real estate TRS is often an index. The one we’ll be using in our example is the Solactive Equal Weight Canada REIT Index. It was created in 2011 with a base value of 100 points. In May 2019, the index value was around 237. The index is denominated in Canadian dollars. It represents all Canadian REITs, which in 2018 was valued at approximately $60 billion. As of April 30, 2019, the index’s top three constituents and percentages were:
- Summit Industrial Income REI 4.88%
- Killam Apartment Real Estate 4.79%
- Northwest Healthcare Properties REIT 4.75%
Real Estate TRS
In a real estate TRS, the receiver is the counterparty seeking exposure to the real estate reference asset. To gain that exposure, the receiver makes payments tied to a floating rate index, such as LIBOR, plus a spread. The effect is to transfer the risk of holding the reference asset from the payer to the receiver. This is often done as a hedge against a market decline in the reference asset. In a hedge transaction, the payer owns the reference asset, but ships off any income and gain/losses to the receiver. In return, the receiver agrees to pay the floating interest plus spread from the specified index.
Alternatively, the receiver may feel that the reference asset will gain in value, and therefore is happy to buy the asset’s income and gain/loss in exchange for paying a cash flow corresponding to the floating rate index and spread. The receiver need not own any part of the reference asset. Indeed, it need not own any real estate investments at all.
A REIT naturally fills the role of the total return payer. The REIT owns property and wishes to hedge against any loss of income or value from its holdings. If the REIT becomes pessimistic about the real estate market, it would welcome the chance to exchange its feared losses for a positive cash flow from a floating rate index, since its not in a position to sell-off its holdings wholesale.
Real Estate TRS ETF
In a physical ETF, the fund holds shares of the underlying securities. Swap ETFs are a different breed, in that they need not hold any underlying shares. Instead, the ETF is the total return receiver and holds sufficient assets to pay the counterparty — the total return payer– the floating-rate cash flow named in the swap contract. In return, the payer pays the ETF the income and gains from the reference asset.
One such ETF is the Horizons Equal Weight Canada REIT Index ETF (HCRE). It was launched on January 23, 2019 as a swap ETF, in which it is the receiver of cash flows replicating the income and gains/losses from an investment in the index’s underlying REITs. In return, it pays its counterparties, Schedule 1 Canadian banks with a minimum A-credit rating, cash flows replicating the return from a floating rate index. As the receiver, HCRE undertakes the same risks as that of a physical ETF based on the same reference asset.
Benefits of a TRS ETF
At this point, you may ask why HCRE would bother with swaps instead of holding the underlying assets outright and/or through futures contracts. Three compelling reasons provide an explanation:
- Efficiency: HCRE can obtain the equivalent returns of a physical ETF without having to own any of the properties. Furthermore, it costs nothing to enter into a swap (except for commissions). Because it doesn’t have to worry about buying and selling REIT shares, it reduces tracking error between the ETF and REITs.
- Taxes: HCRE doesn’t own any of the reference asset or its constituents. It therefore does not have to distribute income and gains. Compare that to a physical REIT ETF, which must distribute at least 90% of its taxable income and gains to shareholders. Because HCRE doesn’t distribute its earnings, the share NAV rises over time. Shareholders realize their gains only when they sell their shares, or the ETF liquidates. Only then will they owe taxes — capital gains taxes.
- Reinvestment: ETFs usually compound their earnings on a monthly or quarterly basis. HCRE immediately compounds its earnings on the ex-dividend date of each REIT. More efficient compounding can result in better returns for investors.
Risks of a TRS ETF
A TRS ETF must cope with certain risks, including:
- Counterparty risk: This is the risk that a counterparty will fail to fulfill its cash flow commitments. HCRE manages this risk by transacting only with financially strong counterparties and by limiting exposure to any one counterparty to no more than 10% of the ETF’s net asset value, for a period of 30 days or more. If a counterparty goes bankrupt, the ETF may suffer a loss.
- Real estate investment risk: HCRE bears the risk of a decline in the value of the REITs within the index.
- Interest rate risk: The ETF must deliver to its counterparty the cash flows mirroring a floating-rate index. If the ETF cannot earn the cash flows it must deliver, it will suffer a loss.
For a complete statement of its risks, see the HCRE prospectus.
Characteristics of Real Estate Swaps
The following table summarizes the primary characteristics of real estate swaps.
| CHARACTERISTIC | COMMENT |
|---|---|
| Minimum investment | None. You can enter into a swap for $0. |
| Liquidity | Illiquid. These are private contracts that, for the most part, do not trade on a public market. |
| Control | Complete. The parties agree on all the terms of the contract. |
| Diversification | Variable. The swap applies to only the reference asset, which may or may not be diversified. |
| Leverage | High. The counterparties can enter into a swap without any margin, premiums or purchases. |
Summary
Swaps are a way to get the benefits (and suffer the risks) of owning an asset without actually owning it. They are highly leveraged and provide certain efficiencies that can benefit investors.
This concludes our series on ways to invest in real estate. We hope you found this survey useful as a starting point for your own research into the topic.
This article is intended as educational content and is not a substitute for advice from a licensed investment advisor.