The property market is one of the last major asset classes not to have a mature derivatives market. In the UK, this has historically been due to a prohibitive tax and regulatory framework and the absence of market-makers, typically banks, which could issue over-the-counter contracts.
In 2005, just over £1bn (e1.5bn) in property derivatives was traded, which equates to 0.2% of the underlying market. Compared with many other developed derivatives markets, such as the equity and government bond markets, this is a drop in the ocean.
It is important to remember the caution with which market participants treat fledgling markets. It was years before we saw any meaningful
volumes in the interest rate derivatives market. Likewise, the credit derivatives market only
began to flourish in the late 1990s, following its launch nearly a decade earlier.
However, we expect property derivatives to flourish on a shorter time-scale, especially now that the tax and regulatory barriers have been removed.
Until now, the main way to gain exposure to UK property was through the All Property Index, which comprises the office, retail and industrial UK property sectors. However, the index does not provide a means to hedge against, or speculate on, specific sectors.
We believe this need will drive demand for
property derivatives. In November 2005, ABN AMRO acted as market maker for the first sector-specific property derivatives trade, a swap of the UK retail sector versus the All Property Index. Other sector-specific trades have been executed since including the first sector-versus-sector swap in January 2006.
Sector-specific trades allow property managers
to hedge risk precisely and provide an opportunity for investors, such as hedge funds, to speculate. The benefits of this can be seen when we look at the volatility between each property sector.
The high cost of trading physical property, the time involved to transact and property’s nature as a lumpy asset mean that property managers never achieve an optimal balance between risk and return. Property derivatives offer managers an efficient means to achieve this balance.
They also give speculators a more practical means to gain exposure to the property market. This includes investors with a short-term investment horizon (one to two years) who are otherwise prohibited from participating by lengthy transaction times when dealing with physical property. Once liquidity increases, this investor base will grow exponentially.
The market is currently undergoing a learning process to understand property derivatives,
how they can be used and the diversification and hedging benefits they bring. Mandates are
also being modified to allow portfolio managers
Although the UK property market has led the way in producing the first sector-specific property trade, we expect continental Europe will not be far behind. The Netherlands, France, Ireland and Sweden all have robust property indices and similar hedging and speculative needs to those in the UK.
ABN AMRO is strongly committed to this market and was the first bank to establish a dedicated property derivatives desk. This focuses on the sector-specific short end of the market where we expect liquidity to grow the most.
We expect to see an expanding number of participants in 2006 as the market gains a greater understanding of property derivatives and the benefits they can bring to portfolio management and yield enhancement.
Niall Cameron is global head of traded markets for ABN AMRO