Hedging your portfolio
Away from the banner headlines covering the slow and painful progress towards the creation of UK real estate investment trusts (REITs), a quiet revolution has been taking place in the UK with respect to real estate derivatives.
This development will make the UK the first place to have a major real estate derivatives market. If it takes off, the concept could be exported to countries across Europe, to the benefit of both existing and prospective investors in real estate.
Not surprisingly, in a market where transaction tax on direct real estate assets has risen to 4%, making the tactical management of real estate portfolios difficult, the potential to use real estate derivatives is creating a lot of excitement among investors.
Also, we see that there is substantial capital currently trying to buy UK real estate returns just when signs are emerging that some investors are beginning to leave the market. This divergence of view on the asset class is ideal for stimulating liquidity in the derivatives market.
So, why is a real estate derivative useful?
The basic purpose of a real estate derivative, like any other derivative, is the shifting of risk. Real estate derivatives are particularly useful in the context of real estate, because the intrinsic characteristics of real estate make it difficult to shift risk quickly and cost effectively by way of actual transactions in real estate itself. For example:
n Real estate is illiquid and therefore slow to transact. On the other hand, real estate derivatives will ultimately be able to be transacted in minutes;
n Transaction costs are high: rebalancing a portfolio from one sector to another could (in the UK) cost 7% (agents fees of 3% and stamp duty land tax (SDLT) of 4%), which is very difficult to recover in times of low inflation. Contrast this with real estate derivatives which are not subject to stamp duty nor SDLT;
n Lot size can cause difficulties: small investors (either private individuals or small pension funds) find it impossible to invest in large properties and large investors find it cumbersome to invest in small properties such as residential. There is no upper or lower limit to the size of real estate derivative that can be entered into;
n Often suitable property is simply not available for purchase. It is perfectly possible, however, to enter into a real estate derivative with reference to the value of a particular property or index even if the real estate is not for sale. Indeed a real estate derivative could be for a notional principal well in excess of the value of an underlying property or the total value of real estate underpinning a sector index;
n It could be desirable to keep a prized asset through a cycle, rather than having to sell it as part of a portfolio rebalancing exercise and then repurchase it again later in the cycle (indeed it might not even be possible). A real estate derivative would allow this objective to be achieved;
n Real estate exposure can be achieved through the use of real estate derivatives without additional
Real estate derivatives are usually thought of as being a portfolio management tool and this is certainly true. However, they also allow investors to extract more value from their stock.
The most obvious use for derivatives relates to their use by investors to increase or decrease exposure to real estate markets quickly (either national or, potentially, regional or land use sector markets). In a deep and liquid real estate derivatives market, new strategic positions in real estate markets could be implemented, using standard documentation, in a matter of hours rather than the months it currently takes to move portfolios of actual properties around.
This ability to switch exposures quickly could permit (for the first time ever) active tactical asset allocation between market segments in a real estate portfolio.
Index based derivatives are also useful for giving investors access to the performance of a whole market or market segment. As such, they allow small investors to gain ‘synthetic’ exposure to large lot size markets which they otherwise could not contemplate investing in. Similarly, some large investors could use derivatives to gain access to small lot size markets like residential or industrial real estate. This characteristic of derivatives effectively allows investors to better optimise their portfolios and diversify risk.
Derivatives also allow investors to hedge against adverse market movements. If you are ‘long’ in retail real estate but fear a market downturn then, by selling a retail sector derivative, you can protect yourself. If the market does go down, your direct properties suffer poor performance. However, you end up paying less through your derivative contract, thus maintaining returns.
Real estate derivatives also allow investors to get more out of their stock. Currently, if a real estate fund manager comes under pressure to sell, it is often the best, prime, most liquid assets in the fund - assets that may never be regained - that are sold. However, derivatives would allow the same manager to sell down a generalised exposure to real estate and keep the desired assets in the portfolio. At the end of the contract, the exposure, including those assets, revert to their original positions. If the assets deserved to be kept they should have outperformed and, because only a generalised exposure was sold down, that outperformance is retained by the investor.
Similarly, when buying, if an investor can extract outperformance from assets in a given sector but does not like the prospects for that sector in general, then they can go out and buy direct assets in the preferred sector but then hedge out the generalised exposure to the sector. Here, the manager earns outperformance on the actual assets but has hedged out the structural problems with in the sector. As such, under any market condition, the manager can exploit specialist skills to enhance outperformance.
Phil Nicklin is senior real estate tax partner at Deloitte
Paul McNamara is head of real estate research at Prudential
History of UK real estate derivatives
As the home of the Investment Property Databank (IPD), the UK is fortunate in having had a robust and representative index of direct real estate asset performance since the mid-1980s.
The presence of such a resource was not lost on visionaries seeking to find ways to make real estate a more liquid form of asset who, as early as the late-1980s, promoted the idea of an exchange-traded market for index-futures using IPD indices.
Although the timing of the London Futures and Options Exchange (London FOX) experiment could not have been worse, occurring just when the UK real estate market was moving from ‘boom to bust’, the seeds of an idea had truly been sown.
Throughout the 1990s, further experimentation with the idea of real estate index-based derivatives continued. Barclays Capital used real estate derivatives based on the IPD ‘All Property’ index to hedge the risk of direct real estate being carried on their books after the collapse of the UK market in 1991/92. The knowledge gained allowed them to then work with Aberdeen Real Estate Investors (and now with Protego Real Estate Investors) to launch further derivative instruments in the mid- and late-1990s. Elsewhere, some smaller initiatives were being considered but did not turn into concrete action.
The Barclays-related initiatives have proved the most successful of the attempts to get a real estate derivatives market going in the UK. However, the growth of the market was held back by a number of factors, all of which have now been removed.
Over and above the general issue of the understanding of (and conservatism about) derivatives by real estate professionals, the two main impediments to getting liquidity into the market were, firstly, that UK regulators were unwilling to allow life assurers to count such assets in their measures of fund solvency and, secondly, that the taxation of real estate derivatives was unfair and uncertain. Together these issues meant that most of the UK real estate investment market would not use derivatives, killing liquidity.
UK regulators’ concerns were essentially placated by a combination of the Property Derivatives Users Association and the Association of British Insurers in November 2002 and, in September 2004, the tax impediments which were resolved after real estate industry consultation with the UK tax authorities.
These regulatory and taxation changes, combined with a decade of education by industry bodies, the Barclays team and others, have created an environment where investors are now free and able to use real estate derivatives.
Phil Nicklin and Paul McNamara