Gary McNamara of DTZ and Andrew Jeyarajah of Tullett Prebon have been collaborating in London’s nascent property derivatives market. They agreed to share their thoughts with IPE Real Estate
These are exciting times for the capital market’s real estate sector with derivatives being the flavour of the month.
In essence, a derivative is a financial instrument which involves the trading of rights and obligations relating to an underlying product without any actual transfer of ownership of the underlying asset. Many assets can be used as the ‘underlying’ for a derivative. The most common include equities, interest rates, currency and commodities.
The key foundations of a derivatives market include a benchmark which is broadly accepted by the market, widespread acknowledgement that the asset has some value from a business risk point of view and opposing views on the future value of the asset.
Investors take a view and enter into a contract with another party, generally via some intermediary. The contract is settled at some pre-determined date based on movements in the benchmark.
The benchmark used for property derivatives is the IPD Annual Index which covers approximately 11,000 directly-held UK property investments. This market was revalued in December 2005 at just over £147bn (e214bn).
It’s estimated that this coverage represents just over 75% of the total combined value of the property assets held by UK institutions, trusts, partnerships and listed property companies, and just under 50% of the total, professionally-managed, UK property investment market. The monthly index comprises 3,300 properties worth just over £30bn as of the end of May 2005.
Interest in property derivatives received a boost following two key changes in recent years. In 2002 life insurance companies were granted permission to include derivatives in their solvency ratios. Further tax changes in September 2004 allowed investors to offset capital gains and losses on derivative products against direct property.
Losses on property derivatives can also be carried back for a maximum of two years. This fact, combined with an ongoing problem of too much money chasing too little product, has created a conducive environment for the development of property derivatives in the UK.
Last year was the first full year of trading property derivatives with approximately £1bn being traded. So far this year, approximately £200m has been traded. All of the UK commercial property derivative contracts agreed to date are formally priced off the IPD UK Annual Index.
Property derivative trades so far have been done on the all-property, all-office & all-retail index. This has come in different forms including the all retail index being traded against the all-property and against LIBOR, and the all-office being traded against the all-property and against LIBOR. To date the market participants have included pension/life funds, property funds, real estate companies and property developers.
The trades that have occurred have been done for various reasons. Property companies have looked to sell derivatives in order to lock in returns and hedge their market exposure, while other institutions have used derivatives as a means to gain quick access to returns related to investing in direct property. This has happened over a range of contract maturities and prices, the latter moving in line with market sentiment.
At present the most liquidity is available on the all-property index and prices are available in contract maturities ranging from one to 10 years. This means that there is a price that shows the levels at which counterparties are willing to receive/pay for all property total return. The market for office and retail is becoming more liquid by the week and contracts from one/three years are being actively traded.
Interest rate derivatives may provide a glimpse into the future for property derivatives. During the early days of interest rate swaps it would have been difficult to imagine that future interest rates might be predicted by a derivative. However, analysts now routinely interpret swap rates for trends.
A mature market for property derivatives could see returns forecasted by three-year swap rates on the IPD index for shopping centres, for example. Banks will most likely use derivatives routinely to hedge their property loan portfolios.
The spread paid by buyers of exposure is simply determined by supply and demand in the market. Complex option pricing strategies do not form part of this immature market. However, in the long term, with a wide divergence of views and derivative products, and various types of buyers and sellers, pricing of these products will likely become complex.
There is growing interest from overseas investors both within the UK market and European-based property derivatives. This could give rise to international swaps, such as swapping all property UK against France. There is also growing interest in the sub-sectors within the UK.
This market is moving forward at a fast pace with the volume of transactions increasing weekly. The derivatives are also attracting interest from people who are outside the property world but are eager to gain quick exposure to returns linked to this desirable asset class.