Increasing volatility of credit
Derivatives reflect the market’s sentiment and expectation quickly in their prices. Improved understanding and transparency could foster the acceptance of real estate as an asset class. Further, derivative markets should provide accurate signals for an optimal allocation of capital and risk.
Higher attractiveness and better risk management possibilities due to property derivatives could drive property prices generally upward. In other words, the risk premium and accordingly the cost of capital shrinks, since risk can better be measured and managed. However, this will only occur when there is enough liquidity and risk management opportunities. The investment bank Merrill Lynch estimates that this scenario can begin to happen if derivative volumes traded reach at least the transaction value of direct property. The bank estimates the critical size in the UK to be GB £50 billion turnover per year for the commercial sector. With the rapid growth of the UK property derivatives market, such a feedback effect could soon be seen to start.
Another feedback effect concerns activity. Experts say that the introduction of a derivatives market potentially reduces trading volume in the spot market, since the transfer of risk and return through derivatives make physical transaction at least partly obsolete. However, evidence is mixed. Other studies show that the existence of derivatives have actually improved activity in the related spot market.
However, there is some concern that a successful derivatives market will lead to fewer transactions in the underlying property market, reducing the base market’s liquidity and increasing credit volatility. This may have a significant impact on the underlying indices used to measure property returns, particularly the capital growth indices, which rely on valuations based on transactional evidence. Derivative advocates argue that there will always be demand for physical property from investors who believe they can beat the market through picking individual properties and actively managing them.
Exchange of cash flows between loans
A PTRS is a simple exchange of cash flows between two counterparties based on a notional amount. On one side, the buyer, taking a long position on commercial property, pays a fixed percentage interest rate or LIBOR plus a spread. In return, he or she receives a cashflow based on the annual total return of the property index. The seller, taking the equivalent short position, pays and receives cashflows that are exactly opposite.
The interest rate used by the market is typically the three-month LIBOR. The spread that is added reflects expectations of the future performance of the index, and what buyers and sellers are prepared to accept to take the position (see the property spread). In January 2008, many banks switched from the LIBOR-based to a fixed interest rate convention.
In the event that the annual total return is negative, i.e. if the capital value drops sufficiently to wipe out income returns, the total return buyer pays that negative return to the seller, in addition to the quarterly interest payments. The property index commonly used is an annual index, which is based on the actual performance of a large number of institutional portfolios and comprises an income or rental and a capital growth element.
In addition to swaps, contracts-for-difference (CFDs) are used as trading instruments. For deals on residential indices, such as the Halifax House Price Index, CFDs are already common. A CFD represents an index that is artificially set at 100 when the deal is done. Investors and hedgers then state the price at which they are willing to buy or sell the index at maturity. If two counterparties agree on a three-year deal at 112 and the index rises to 116, then the buyer receives 116 ? 112 = 4 times the contract size from the seller. The transactions are cash free until maturity, when profits and losses are settled. Many market participants find CFDs more intuitive than swaps.
The Credit Property Total Return Swap
By December 2007, property derivatives deals have been made public in Australia, France, Germany, Hong Kong, Italy, Japan, Switzerland, the UK and the US. Deals were referenced to both commercial and residential properties. Derivatives that reflect commercial real estate are typically tied to appraisal-based indices while derivatives that reflect owner-occupied residential housing usually use transaction-based indices as the underlying instrument (see property indices).
Most contracts are still executed as matched bargain trades between a buyer and a seller, with pricing determined through negotiations between them. As the market becomes more liquid, standardized contracts will become available directly from intermediaries. They will price the contracts and assume the risk of finding a suitable counterparty.
Several derivative structures have been developed and traded. So far, the bulk of trades has been structured as over-the-counter (OTC) swap contracts. In addition, a few derivatives are listed and traded on public exchanges. Most market participants are aiming to create derivatives that replicate the familiar characteristics of direct property investment, i.e. quarterly rental income and annual capital growth. As the market expands, the variety of structures increases. Derivative markets have a particular order of development and it is not unusual for options to develop after futures and swaps, because the option writers require these instruments to be liquid in order to hedge their positions.
The Property Total Return Swap (PTRS) is the most popular format and, in principle, swaps a fixed or floating interest payment for an amount calculated with reference to total returns on the property index, which consists of both rental income and capital gains (see swap transactions). The swap structure is quite simple and the variations usually only involve the choice of the index (country, sector and rental, and/or capital growth index), the tenor and the payment conventions.
Cash-settled payday loan contracts are available
After the launch of futures and options on regional home prices, CME announced a partnership with the commercial real estate index provider Global Real Analytics (GRA) on 6 September 2006. They listed future and option contracts based on the S&P/GRA Commercial Real Estate Indices (CREX) on 29 October 2007.
The S&P/GRA CREX indices capture underlying real estate dynamics by tracking transaction-based price changes in diverse property sectors and geographic regions. GRA has a 20-year history of capturing data and sees the new indices as a natural extension, suited for the use of publicly traded futures contracts.
Ten quarterly cash-settled contracts are available: a national composite index, five regional indices (Desert Mountain West, Mid-Atlantic South, Northeast, Midwest and Pacific West) and four national property type indices (retail, office, apartment and warehouse properties).
CME expects the users of the new property contracts to be different from those trading in housing derivatives. If someone hedges against house-price declines in an area, he or she develops or buys a house there. The commercial contracts, on the other hand, are designed for larger investors who hold commercial properties in their portfolios, such as pension funds and REITs.
To hedge real estate or home price declines, individuals can purchase put options based on a particular index. If prices fall, investors will naturally see the value of their real estate holdings decline, but they offset the losses with gains in the put options. The CME hopes that there will be enough speculators in the market to take the other side of the transactions.
