Property derivatives are a relatively small part of the universe of investible products in property, but they are becoming an increasingly important part, with a range of new property derivative structures being offered to investors for the first time. To date, the main participants in this marketplace have been UK or European pension fund investors, who recognise the benefits of this form of investment product, as opposed to the alternatives of direct or collective property investment products.
Property derivative structures provide investors with a means of managing their property market risk, by up-weighting or down-weighting their property exposure levels, by establishing ‘long’ or ‘short’, positions, through property derivative structures. In the direct property market, there is no means for shorting the market, except through the implementation of property derivative overlays.
For the most part however, investors use property derivative structures as a cost effective means of accessing property market returns, through a more liquid and transparent investment medium.
There are two ways in which investors utilise property derivative structures within their portfolios.
For the smaller and medium size pension fund investors, property derivative structures tend to be used as a ‘core’ exposure to the market. As such, the property derivatives will be held as an alternative to either direct, or even collective property investment products. To that extent, the property derivatives are held for the longevity of the chosen investment period or, dependant upon the structure of the derivative, until it matures.
For the medium and larger size pension fund investors, property derivative structures tend to be used more tactically.
It may be for example, that an investor has money to invest in the property market, but cannot find an appropriate direct or indirect investment opportunity to acquire. Rather than having committed money awaiting investment being held in cash, with the risk of not being invested, the investor might acquire a property derivative structure, as a temporary means of up-weighting its exposure to the market, with a view to liquidating that position in due course. The proceeds from the sale of the derivative would then be reinvested into suitable direct or indirect investment opportunities, as and when they arise.
Alternatively, property derivatives are complementary to an investors’ direct or indirect portfolio as a more liquid component which can, if required, be regularly and cost effectively traded. As such, an investor might have a core direct or indirect portfolio, and the property derivative will be an overlay to that portfolio. Property derivative structures can therefore provide investors with a degree of flexibility in managing their portfolio.
There are two types of property derivative structure currently available to investors.
Firstly, there are index-based derivative structures, based upon the valuations of ‘real’ property. Those launched to date are based upon the Investment Property Databank (IPD) annual indices. IPD is recognised in Europe as the leading index provider for measuring real property performance.
In the UK, for example, the IPD annual index comprises circa 11,500 properties, with a value of circa €150bn, across all sectors and all regions of the UK commercial property market.
Index based derivative structures in the UK have existed since 1994. Since their origination, a total of circa €1.5bn have been transacted. In the UK, there have been two types IPD Annual Index based property derivative structures – Property Index Certificates (‘PICs’) and Property Index Forwards (‘PIFs’). Both of these structures were originated by Barclays Bank and our company Aberdeen Property Investors (API).
PICs and PIFs are passive, index- based investment instruments, paying investors the capital and income return (PICs) or capital only return (PIFs), according to the IPD annual index.
PICs in the UK have become a recognised form of indirect property investment, in particular for pension funds, charities, and foundations, in the UK and Europe, with the following benefits
o Index tracking with certainty: -PICs and PIFs are structured so that if held to maturity, they will track the movement of the IPD Annual Index, less costs.
o Strong credit: -Barclays Bank has been the issuer of PICs or counterparty to PIFs in all previous issues (Standard & Poor’s AA rating).
o Low risk access to market:
- PICs and PIFs provide investors with complete diversification to the UK commercial property market, as returns are derived from the IPD Annual Index universe, across all sectors and all regions.
o Competitive costs: -PICs and PIFs provide investors with a cost competitive option, when comparing the transaction and management costs of alternatives.
o Instantaneous exposure: - Investors achieve instantaneous exposure to the commercial property market, as defined by the IPD annual index. An instrument of this type does not depend upon the acquisition of real property. This eliminates the uncertainty of implementing investment decisions in the direct or indirect property investment markets.
o Enhanced liquidity and price transparency:
- UK PICs are listed on the London Stock Exchange and offer the potential of enhanced liquidity, as well as price transparency. In the last issue of UK PICs, API and Barclays Capital have transacted circa €150m of PICs in the secondary market, from an initial issue size of circa €240m.
o Flexible time horizons: - Investors usually have a choice of maturity dates.
IPD has commenced property benchmarking services in most European countries. To that extent, there are opportunities to create similar derivative structures, based upon both the UK PIC and PIF models.
Currently, there are four markets where the IPD indices are credible and robust enough to create PIC and PIF type structures. These include the UK, Sweden, Netherlands, and Ireland.
API/Barclays Capital were recently involved in the origination, structuring and marketing of Swedish PICs to investors. This was the first time a property derivative structure, based upon an IPD Annual Index, had been structured, outside the UK. Swedish PICs were structured in a similar way to UK PICs, but based upon the Swedish SFI/IPD Annual Index.
Owing to investors short term concerns about the Swedish commercial property market, as well as the severe time constraints imposed upon the issue, particularly as this was a brand new product for the Nordic region, API/Barclays Capital were unsuccessful in sourcing sufficient investors to proceed with the issue. API/Barclays Capital expects to reapproach the market, at a later stage.
In the UK, there has been a major breakthrough in the development of PICs and PIFs. Life Insurance companies, the most likely sellers of property market risk, were previously unable to include property derivative structures, based upon IPD indices, in their solvency ratios.
Subject to certain conditions, the FSA has now ruled, that property derivatives may now be considered admissible assets. As a result, we would expect the volume of property derivatives contracts to increase substantially.
In addition to the geographical expansion of these IPD based contracts, API/Barclays Capital are also considering the introduction of sector and sub-sector PIC and PIF contracts, as opposed to IPD All Property structures.
In conjunction with TD Securities, the capital markets arm of Toronto Dominion Bank, API are keen to create a market in property derivative structures linked to the European Public Real Estate Association (‘EPRA’) series of indices.
These indices measure the price performance of European publicly listed property companies, hence these instruments represent an easy way to access the returns of publicly listed property companies, as an alternative to other direct or indirect unlisted property investment products. The advantage of EPRA linked derivatives is that they are based on an index composed of stocks that can be bought or sold, at any time. This means that prices for buying and selling these derivatives can always be quoted, as long as underlying stock markets are open – the marketmaker can access the underlying securities and is not therefore, solely dependent on demand and supply of the derivatives themselves. Furthermore the value of a derivative will follow prices changes in the index throughout the term of the instrument and not just at maturity.
There is a further benefit for potential investors – continuous availability of the stocks underlying the EPRA indices means that options can be priced. Options allow market participants to construct a risk/return profile to suit their individual circumstances. For example, a risk-averse investor may wish to buy an option that gives unlimited geared exposure to price appreciation for a defined upfront cost.
EPRA-based contracts may be used by smaller pension funds as a proxy for direct property investment, whilst for the medium and larger pension funds, we would expect EPRA-based derivatives to be used more tactically, as a means of ‘adding value’ to an investors’ existing direct or indirect portfolio. For example, arbitrage opportunities will arise, providing investors with an ability to add value by buying or selling EPRA contracts, depending upon levels of discount to NAV and investors’ market expectations.
Charles Weeks is director at Aberdeen Property Investors (API) in London