Vision of the future
I believe that over the next five years property derivatives, from what is now a firm base in the UK property market, will spread progressively through Europe and around the world. It will proceed to the point where they will be playing a significant part in the strategies and shorter-terms tactics of a large number of medium-size and large property investors as well as financial players who do not normally participate directly in real estate.
There are several compelling reasons for taking this view, including the great advantages in speed, certainty and cost that property derivatives bring to mainstream investors, compared with any other alternative and the fact that it will extend access to the property market to those who would otherwise ignore it. Derivatives will therefore lubricate the system, leave more money within it for investors and create greater liquidity.
These advantages are significant but not well enough understood by many investors. However, before looking at them in greater detail it is worth outlining the history and growth of the UK market and addressing the practical issue of how easy it is for these instruments to spread across Europe, or what has to happen to enable this.
The use of these instruments is entirely dependent on the establishment of an index in any country, which is likely to be regarded by both sides of the transaction as being an authoritative representation of the market.
This means an IPD product, in Europe at any rate, although one or two important countries elsewhere in the world may have comparable indices.
For my part, I do not believe that there is any future in attempting to create derivatives on real property assets or portfolios, since such structures would imply unavoidable conflicts of interest and attract the attention of governments intent on taxing them, since the only real reason for their existence would be tax avoidance. In any event, they would in practice be less attractive than an open-ended fund, for most people on the buy side.
UK market growth
In the 10 years since 1994, around £800m (e1.2bn) of total return swaps (TRS) and property index certificates (PICs) have been transacted, with lives of one to seven years, together with around £400m in property index forwards (PIFs), between 1996 and 1998.
PICs are an instrument that I devised while at BZW (the predecessor of Barclays Capital) in 1993/94. Although my colleague Charles Weeks and I left the Barclays group when our company was sold in 2000 (and have since set up Protego Real Estate Investors) we have participated in arranging all of these transactions with a small team at BZW / Barclays Capital.
All of these instruments were at the UK IPD All Property level, although we did structure an additional PIC issue on the Swedish market, which was only withdrawn at an advanced stage due to a regulatory obstacle.
In 2005, the marketplace began to grow significantly after the successful resolution of some tax issues and, importantly, the reclassification of the instruments by the Financial Services Authority as “admissible assets” for insurance companies, which had not been the case previously. This resulted in a further £800m of transactions in these instruments, being undertaken by the Barclays Capital / Protego team, whilst other banks have undertaken a further £200m or more of TRS. Notable in this is ABN AMRO, which has dealt for the first time in sector instruments, specifically the retail and office segments of the UK IPD index.
The Protego/Barclays Capital team has also transacted a number of secondary market transactions in PICs demonstrating very fast moves into cash. One trade involved the forward sale of the index for 2007/08.
This mood of expansion has been reflected in the formation of the Property Derivatives Interest Group (an offshoot of the UK’s Investment Property Forum); the advent of the Property Derivatives Trading Forum (a simulated trading experience, which has attracted numerous investors); and the entry of inter-dealer brokers, usually in partnership with a property consultant, who are all seeking to establish UK trading platforms.
What are property derivatives?
I will ignore PIFs in my definition, since they are not currently in vogue, except to say that they are akin to any forward/futures contract in other derivatives markets.
It would seem that all current activity starts with a TRS whereby a party wishing to “hedge” or “sell” current property market exposure will contract to pay, for a defined period likely to be between one and seven years, the annual income return on the relevant index and the capital return over the period should values increase.
In return, a bank will contract to pay a rate of interest on the agreed capital exposure, based on LIBOR/
EURIBOR plus or minus a margin. Should capital values fall over the period of the trade, rather than rise, the bank will pay the seller an appropriate sum. Thus the derivative is a swap of floating rates of income return on property for a financial return in combination with a capital hedge. The LIBOR/EURIBOR element could also be fixed. Clearly, the key factor in this, apart from the chosen life of the instrument, is the size of the premium or discount within the overall interest rate paid.
Typically, a bank will then mirror this trade in the opposite direction with another party, whereby it will contract to pay the relevant IPD index in return for a higher interest rate. The bank’s interest is therefore in taking the spread between the two rates of interest. The two parties on either end are therefore paying and receiving the property index respectively.
In the case of Barclays Capital and Protego, however, our established approach is to wrap the bank’s long exposure to the index into a Eurobond structure. This, unlike a TRS, is a cash instrument and is traded on the London Stock Exchange. It pays a coupon equivalent to the IPD income return (minus 15 basis points) and reflects the movement of the capital index, either positively or negatively, in the return of capital to the investor at the end of the life of the bond.
Aside from the UK, the first US transaction is believed to have taken place recently through CSFB. The Netherlands is likely to produce a transaction in the near future.
Interest is developing in many other areas, including Australia, France, Ireland, Germany, Switzerland and the Nordic region. IPD itself runs some 17 indices in various countries, of which 13 are in Europe.
The ultimate criterion of whether any of these indices is capable of supporting a derivative instrument is proven investor acceptability. But the most likely issues will be the percentage of the overall market the index covers, the representativeness of its spread and, perhaps most importantly, the credibility of the valuation process commonly adopted by the constituent funds.
In addition , it would be convenient to have monthly or quarterly updates of the index, sufficient depth at each segment level and not too much concentration of index results stemming from individual institutions or valuers.
Driving growth in Europe
In my view, there are two big picture issues which are likely to drive investors in the direction of derivatives. The first is the fact that huge investor demand is mirrored in a highly active transactions market in direct and indirect real estate. This liquidity is welcome but comes at an enormous cost, which derivatives can offset.
Secondly, old, established real estate investors are typically hugely concentrated in their domestic market and need to internationalise their portfolios while new entrants to property tend to look internationally from the start. This will almost all be carried out indirectly and derivatives could make a big contribution to this.
So, property derivatives can create an instant “buy” or “sell” effect in investors’ portfolios, whilst avoiding or postponing the need to trade assets. This means investors can meet their strategic and tactical aims instantly and save substantial time and money.
These strategic or tactical aims at the asset allocation level, going short or long, are principally between asset classes, countries and market sectors.
These are what I would consider the frontline applications for a multi-asset class or large investor. However, two additional functions are present, incidentally, in any transaction that can also be the primary reason for undertaking it.
Selling the index means separating beta from alpha risk. In other words, an investor can keep the added value he creates whilst selling off the market risk. This has very great attractions to investors such as property companies or REITs whose only option in the past has been to play with the levels of debt in differing market conditions, or to sell off hard-won assets. Thus, the derivative contract is a tool for raising or reducing specific property risk and also introduces, for a user of debt, a capital hedge into their financing structure.
Hedge funds, banks and others with a different perspective on real estate may participate in such a market if they perceive that the market is mispricing risk. That the consensus of the market will do so is inevitable. Whether anyone is smart enough to spot it is another matter.
Will REITs affect this outlook?
The short answer is no. The greater liquidity offered by REITs compared with the direct market for increasing or reducing property exposure, or indeed derivatives based on the REITs markets themselves, may appear to have some superficial attraction as an alternative to index derivatives. However, their very different risk profiles, mean they are likely to be used in different ways.
REITs use by property investors, owing to their non-property risk characteristics, is likely to be fairly marginal in their portfolio context and REITs’ natural market is yield-chasing equity investors, whose preferences can change independently of the underlying real estate.
A number of factors are coming together that will ensure the steady spread of this marketplace across Europe.
The instruments themselves are becoming more established and understood: their attractions, particularly in cost saving, are being increasingly recognised; the markets across Europe are becoming more rationally priced for the long-term investor, meaning a range of views on the outlook; there is a big push to gain exposure at the strategic level by cross-border investors and the range of suitable indices provided by IPD and others is rapidly becoming more robust and capable of supporting a variety of instruments.
Perhaps the most obvious reason why we have not seen an early rush to trade so far this year is simply that although property portfolios have grown 30% in value in the last three years in the UK, the likelihood of an overweight position for investors has been thwarted by the 20% growth in equity markets in 2005. Nevertheless, trading is to be expected to come through for all the other reasons set out above.
The other main reason for hesitation is lack of comfort with current prices being quoted in the market. Investors are rapidly grappling with the concept of worth and comparable pricing and a debate is growing. Once this has been undertaken and prices firmed up, more activity will set in. The bigger picture imperatives will ensure a Europe-wide market.