Can the quality of the inflatory hedge of Real Estate be Used for the Creation of a Series of New Innovative Investment Products?

Institutional investors have to optimise their asset-mix in such a way that at any time all future liabilities will be met. Many investors, especially pension funds, need on top of a certain minimum return some compensation for actual inflation. Amongst other reasons as for instance its low correlation with other asset classes, real estate is often added to investment portfolios to contribute to this inflation hedge. Over the last couple of years, due to matters as high operating costs and the desire for international diversification combined with lack of local knowledge, increasingly investors shifted their real estate portfolios from directly owned to indirect holdings via participations in listed and non listed real estate investment vehicles. Also, investors are actively looking for alternative investment products, which match the desired risk return profile and secure their inflation-based obligations. This trend has led to innovative financially structured products, which guarantee annual inflation. One of these products, which has been jointly developed by IEF N.V.1 and Bouwfonds Asset Management BV2, is the Inflation Exchange Contract (IEC). Via this contract, the actual future inflation will be sold to investors. Hedged by real estate portfolios, investors receive an annual compounded inflation (calculated over a fixed coupon amount) for a set time period (the Ïcontract periodó). In order to analyse the risk profile of the IEC, extensive data analysis and modelling has been done. A model using Monte Carlo simulation has been created to estimate the probability that the income stream from real estate portfolio is not able to meet all financing obligations, including those from the IEC. Based on the calculated Îdefault risksÌ ratings can be assigned to the various financial instruments that have been used to finance the real estate portfolios. These ratings can then be used to price the IEC in a transparent way. This paper will discuss the motivation, assumptions, risks and returns of this innovative financially structured product.