Derivatives set for take-off
In recent months there has been much commentary and speculation as to the potential size of a derivatives market in commercial property in the UK, with some claiming a £10bn (€14bn) market could develop. However, to date there has been no public disclosure of any new property derivative contracts having been written, based upon a UK Investment Property Databank Annual Index series. The question that participants may now be asking themselves is whether or not this is the lull before the storm, or indeed, whether market commentators have misinterpreted the potential size and speed of development of this market place altogether.
Until recently, property derivative structures based upon the IPD Annual Index were considered “inadmissible assets” for inclusion in the solvency ratios of UK life insurance companies. Bearing in mind the UK life insurance company sector comprises around 45% by value of the IPD Annual Index Universe, this was a considerable impediment to the development of a property derivatives market place. In addition, the uncertain treatment and perceived risk of asymmetrical taxation for property derivatives meant that investors were unsure how their capital gains and losses might be treated.
Recognising the importance of the resolution of both of these matters, the property industry formed a body to tackle them head on. The Property Derivatives Users Association (PDUA), now part of the Investment Property Forum, lobbied the FSA and was successful in convincing the regulators that subject to certain conditions being met, then property derivative contracts could be considered admissible assets for the solvency ratios of UK life insurance companies. In addition, the recent favourable confirmation of the symmetrical tax treatment of property derivatives, has meant that there are now no further impediments to UK life insurance companies from participating in this market place. This is what has led to expectations of growth in property derivative structures.
It is likely that, similar to the development of other derivative markets, the market will develop driven solely by the commercial need for particular contracts, by the users, as identified by the intermediaries who will then make it happen. This will of course require two way activity, both buyers and sellers of property market risk.
Property is a non-commoditised investment product, transacted in a relatively inefficient and opaque market place. Investors in property tend to be longer term strategic investors rather than shorter term tactical investors. The cost of trading property is often cited as a constraint on liquidity and the development of a more active market place. This has tended to result in a herd instinct in the market place, meaning that at All Property, sector and sub-sector levels, investors expectations of market movements tend to be for them to move in very similar directions, often at the same time, rather than adopting a more contra-cyclical approach.
For these reasons we would expect the market will develop through a series of one-off transactions, driven by those investors who may be seeking to either reduce, or re-weight their portfolios, according to their particular requirements, and who will utilise property derivatives structures rather than direct transactions in the market place, as a means of doing so. Over time we would expect the market to develop further, as investors become more sensitive to the market pricing of derivative structures, depending upon whether the contracts trade at a discount or premium to the underlying spot price.
We would expect that a small number of significant transactions will take place in 2005. To a certain extent, both buyers and sellers of property risk will be more comfortable structuring the contracts based upon 31 December 2004 index numbers, as disclosed by IPD in February 2005, rather than relying upon the IPD Monthly Index or IPD Monthly Index Estimate, which would be the case if the contracts were to be issued this year.
We would expect contracts to be structured not only at the All Property level but also at sector or major sub-sector levels of the market. For the first time, contracts may be structured in particular sub-sectors of the UK commercial property market (eg, high street retail, retail parks, shopping centres, City of London offices, West End offices, rest of UK offices and industrial).
To date only contracts at the All Property level have been structured and decisions therefore tend to be made at the asset allocation level, both in terms of the buying and selling of property market exposure. Should contracts be introduced at the sub-sector level of the market, then this will fall within the realm of the property portfolio manager, who will then be able to implement tactical or strategic re-weightings of his or her portfolio.
In addition, we would also expect to see property derivatives structures being introduced in other markets outside of the UK. IPD is now active in most major commercial property investment markets. Once the IPD indices are considered credible and robust, then there is no reason why similar contracts cannot be structured in those markets.
Charles Weeks is a principal of Protego Real Estate Investors
PICs show the way
The most popular derivative structure to date has been the Barclays Property Index Certificate (PIC). PICs are structured as Eurobonds, listed on the London Stock Exchange and pay investors a quarterly income payment equivalent to the IPD Annual Index, and a capital payment, at redemption, equivalent to the capital appreciation or depreciation of the market, set according to the IPD Annual Index.Benefits to investors include the following:
q Index tracking with certainty - PICs are structured such that if they are held to maturity, they will track the movements of the IPD annual inde;
q Low risk access to the market – Returns are derived from the IPD Annual Index Universe so property specific risk is eliminated;
q Instantaneous Exposure – Investors will be able to achieve instantaneous exposure to the UK commercial property market. A synthetic instrument of this type does not depend on the acquisition of real property and is not secured upon it. This eliminates the uncertainly of implementing investment decisions in the direct real estate market. The only decisions an investor will have to make are to buy, hold or sell;
q Enhanced liquidity and price transparency – PICs are listed on the London Stock Exchange and offer investors the potential for enhanced liquidity, as well as price transparency;
q Strategic or tactical – PICs may represent an investors core strategic exposure to the UK commercial property market, in particular for smaller pension funds. Alternatively, PICs may be a tactical exposure sitting along side investors direct and indirect property investment portfolios, in particular for larger pension fund investors. Overseas pension funds tend to fall into both camps.