Friday, January 2, 2009

A futures contract on real-estate?

Date:01/02/2009 http://www.thehindubusinessline.com/bline/iw/2009/02/01/stories/2009020150471400.htm
If you are wondering why such trading hasn’t taken off in India, it is because these transactions need a lot of ground work to be put in place first.
“Why don’t we have a futures contract on real-estate to hedge the risk of land prices going down?” asked Rahul, a quiet but sharp student. Professor Nicky was taken aback by his question. Where most of the students in her class had difficulty understanding the basic concepts of hedging, this young boy was asking about an instrument which was, well, not so simple, to say the least.

Professor Nicky turned the question to the class to test how much the class knew. And she was in for a pleasant surprise. There were a few hands in the air.
Rachna: “It will be difficult to introduce real-estate futures because the valuation of the underlying product would be difficult. The real-estate market in India is highly fragmented. The prices of land differ widely based on factors such as location and usability, that is commercial, industrial, residential or agricultural”
Praveen added: “Besides, such a market would be very illiquid in India as only prime commercial and residential properties would probably be traded.”
Index of prices
“But, what is the problem here?” interposed Rajshree. “Can’t we create an index of real-estate prices? Just like we have stock indices? We can club the properties belonging to a particular city according to property types”.

Professor Nicky saw a few perplexed looking faces and decided to intervene even though she was happy with the way the discussion was proceeding. She took over from where Rajshree had left.
“See, just like we have an index for FMCG companies or IT companies or banks, similarly, we can create an index of real-estate Prices. Of course these indices will be city or region-wise indices. We would need to determine a base year”.
“Since it would be very tiresome to include all residential property transactions in the index, we take transactions that are above a minimum amount of, let’s say, Rs 25 lakh. Now we can take a weighted average of all the transactions on a weekly or a fortnightly or monthly basis to find the changes in the index.
“However, the index may not give a true and fair picture as the recorded value of these transactions with the government is generally very low to save taxes. But then, it will still be better than having nothing. And slowly, as we move ahead and learn, the issues of heterogeneity and pricing will be sorted out”.
“Ah! If I recall correctly, Chicago Mercantile Exchange and Chicago Board of Trade have such futures traded on such contracts for cities such as New York and Los Angeles. In fact, they also have futures contracts on Real Estate Investment Trusts” exclaimed Richa.
“The students have really started reading,” thought Professor Nicky. “With the job scenario being bleak, many students have become serious and are trying to read more so that they can have an edge over their batch mates in an interview”!

Benefits of futures
“Yes, both the US and the UK have real-estate futures traded on their commodity exchanges for most of the major cities in the country. But can somebody tell me what the benefits of real-estate futures are?” asked Nicky.
Before Nicky could point towards a raised hand, Rohit rattled off, “Hedging for investors and builders, diversification, price discovery, increased information availability and flow, investment tool…”.
“Okay…okay…enough…so all of you are aware of the benefits of real-estate futures. But who has heard of the London Fox?” Thankfully no hands went up this time. Nicky was almost beginning to feel that she was not required in the classroom at all as the students had answers to all her questions.

Keeping them at bay
“London Futures and Options Exchange (FOX) started trading in four property futures contracts in May 1991 and had to suspend trading in October 1991. The reasons were mainly that these contracts were not economically viable. Arbitrage was not possible as short-selling is not allowed in the underlying spot market, which is true in India also.
“Also, the housing indices for various cities would be highly dependent on each other, albeit with lagged effect, due to the cascading effect in the real-estate markets. The transaction costs were also huge, which kept the investors and hedgers at bay.
“Hence, before introducing these futures, the government will have to do a lot of ground work to ensure that they work efficiently and provide the desired benefits to investors and hedgers”.
The class looked satisfied. Everyone had contributed something and everyone had learnt something new. Nicky looked proudly at her students and called it a day.

(Praveen, Rachna, Rahul, Rajshree, Richa and Rohit are students of IBS Hyderabad, class of 2009. Nupur is an Assistant Professor of Finance at IBS Hyderabad.)