Property may be the world’s largest asset class, but getting in and out of it has taken considerable time and money – at least until the advent of property derivatives.
Using property derivatives, it is possible to go long or short on property without all the conventional hassles. It should come as no surprise, then, that this very young market netted £3.5bn (€5.13bn) of deals this year in the UK, and that this is expected to increase exponentially as interest spreads across the globe.
Steady growth
According to Iain Reid, chairman of the Property Derivatives Interest Group and chief executive of Protego Real Estate Investors, “people are expecting steady growth”.
 | Deals in the UK alone should reach £5bn-£7bn this year, he predicts. Estimates as high as “hundreds of billions” across Europe in two years time are “not beyond the bounds of possibility”, says Ed Stacey, managing director, derivatives, at Eurohypo. |
“There’s huge interest in the market,” adds Guy Ratcliffe, head of property derivatives at Abbey Financial Markets. “People are coming into it more from many areas – hedge funds, fund managers and so on, but also in terms of banks and brokers getting involved. There are five to six interbank brokers in the market. Also, there are now a dozen or more banks actively trading on one or both of residential or commercial. It is mostly UK but there are also a small amount of European transactions.”
Property derivatives can be used in three main ways. Firstly, explains Frédéric Ducoulombier, associate professor at Edhec business school, as a way of providing synthetic investment in real estate. Investors can go long or short the market, or a sector of the market (say, central London offices). They can rebalance portfolios “in an easy, prompt and relatively cheap manner”. And they can diversity.
Says Mr Ducoulombier: “For a domestic investor, property derivatives can make the challenging task of diversification of the real estate portfolio manageable. For an international investor, UK real estate derivatives can be seen as a great vehicle to establish a diversified exposure to the local commercial real estate market.”
Protect from fluctuations
Secondly, property derivatives can be used for hedging: to “protect the value of an existing portfolio against market wide fluctuations without liquidating the said portfolio”, as Mr Ducoulombier explains, as well, of course, to extract alpha. Using property derivatives, it is possible to go short property, or certain sectors of the property market, not only without selling any, but without even having any to sell.
Finally, he says, they can be used in arbitrage, to exploit inefficiencies in the real estate market. Investors, he adds, can “take advantage of arbitrage opportunities between direct and indirect real estate, IPD and FTSE/MSS indices – that is, they can sell the expensive index and buy the cheap one”.
The appeal to institutional investors is obvious. Mr Ratcliffe sums it up: “Efficiency and transparency are the two biggest advantages – and the lack of hassle in terms of being able actively to manage property ownership. Institutions can use property derivatives to invest or divest in a particular property sector or country, and execute it very cleanly.”
Mr Stacey agrees, adding: “Very simply, what a derivatives market will give you is speed, flexibility and low cost. If you are a property investor and you want to effect a view you have – buy or sell – then if you do it in the physical market it takes months, possibly years. And it is very expensive. The round trip costs about 7 per cent, by the time you have bought and sold a building. You have lost that before you have even started.”
On top of that, there is the appeal of diversification. Mr Ducoulombier adds that pension funds across the world are looking to increase investments in real estate, in line with their increased strategic allocations to the class. “There is a lot of money around chasing a limited number of buildings – synthetic investments could be seen as easing the burden.”
Remaining wary
That said, he warns that many pension funds will remain wary of property derivatives, “for regulatory, corporate investment policy, education and cultural reasons”. In the short term, he predicts: “The majority of pension schemes will prefer to invest directly in property or indirectly, primarily through unlisted funds and, quite possibly, increasingly through real estate investment trusts (Reits).”
According to Mr Reid, however, institutional investors are already enthusiastic about property derivatives: both as sellers, to hedge against an existing property portfolio as they come concerned about overexposure, and (especially) as buyers. “We must have sold our bonds to at least 100 institutions – a wide range of pension funds of all sizes, insurance companies, property funds, overseas property funds and insurers.”
Mr Ratcliffe agrees that a major challenge for the industry is to educate investors as to the advantages of property derivatives. “A lot of owners of property are institutions who are relatively slow to react,” he says. “They are happy just to look at the pure physical property.”
But he and Mr Stacey are agreed that it would be a big mistake for institutions to see Reits as a rival to property derivatives. “To think they are not complementary is to misunderstand what a Reit is,” says Mr Stacey. Mr Ratcliffe adds: “A Reit is simply a specific tax status for a property company or fund. Derivatives enable investors to take different positions with complex payoff profiles if required, and on specific types of assets only. It is a more transparent way of taking views on actual physical property values.”
Property derivatives are also attractive to hedge funds, as Mr Ratcliffe explains. “We are aware of hedge funds being involved in some transactions to date,” he says, “and there are more looking at it. Some are general hedge funds who want to use it to take specific macro-trading views, but there are also a number of specific hedge funds set up purely to use property derivatives.”
The appeal, he adds, is that it is much easier for hedge funds to execute deals in property derivatives than in the actual property market. “They want to take views on the market, area, countries and sectors, and it is much easier for them to do that. And it is not possible to short real properties, but you can with derivatives.”
No market is perfect, and this one has its challenges and risks. As Mr Ducoulombier explains: “If the commercial real estate market crashes, the value of a derivatives transaction used to go long the market will crash. Naturally, if an investor used the built-in leverage of derivatives to take on more risk than was reasonable given its financial surface, the consequences could be serious. But this, as he points out, is a danger common to all derivatives – “and has more to do with faults in risk management than with inherent design problems with financial tools”.
When it comes to challenges, one major issue, according to Mr Ratcliffe, is that “in certain markets there is not as much information on property pricing, i.e. accurate frequent indices, as we would like”.
Primary challenge
According to Mr Ducoulombier, a primary challenge is that posed to the investment banks issuing the derivatives, which thereby put their balance sheets at risk. As he explains, if a bank cannot get rid of the risk through offsetting deals, it has to hedge it. But with no investable IPD index available, the bank has the choice of: accepting the risk; investing directly in the assets underlying the index; or synthetic hedging, which means identifying assets which, in combination, are highly correlated with the movement of the index.
The second option is problematic because, as Mr Ducoulombier points out “the index we are talking about is based on 11,000-plus buildings and very few are for sale, not to mention that the buildings are indivisible, illiquid, and high denomination assets where you would like something scalable and liquid”.
The solution for direct indices such as IPD is, he suggests, a combination of the second and third options, but “this is quite cutting edge and requires significant research”. This is where FTSE and MSS come in, having teamed up to offer an investment index, which they hope will make them the platform of choice for investment banks looking to write, and to hedge, property derivatives.
UK SHAPING PROPERTY DERIVATIVES DIRECTION AS US AND EUROPE FACE STUMBLING BLOCKS
“For once the UK is so far ahead of the rest of the world, including America, that it is quite a delight,” says Ed Stacey, managing director, derivatives, at Eurohypo.
This, he explains, is thanks to the IPD indices. “Nowhere else really has the quality of indices that we have. You need an index for a derivatives market to work. You need an index people can trust, and you need the underlying things going into the index to be broadly representative of the market.” IPD, thanks to a couple of decades of collating information on prices and rental growth, is able to provide exactly that.
However, the market is now expanding outside the UK. According to Frédéric Ducoulombier, associate professor at Edhec business school, “IPD judges that 10 countries in continental Europe have indices which are mature enough to serve as underlying for property derivatives, but there has only been meagre action to date.”
The first IPD swap in continental Europe was in France, as recently as December 2006, and the first in Germany was reported in January.
Across the Atlantic, the US market has been hindered, Mr Ducoulombier suggests, by a business model adopted by the National Council of Real Estate Investment Fiduciaries (NCREIF), which gave Credit Suisse First Boston a monopoly on developing property derivatives.
This, he says, “did not favour goodwill on the part of investment banks, which could have fostered market development through marketing and liquidity provision”. However, things look more promising since CSFB renounced its exclusivity in October. Says Mr Ducoulombier: “It is understood that some 20 institutions have been discussing licensing agreements with NCREIF since then.”
