Get quick access to the property market with a loan
The British commercial property market is estimated to be about GB£ 600 billion. Pension funds, property companies and other professional investors own about half of this amount according to the Investment Property Forum (IPF) the parent company of PDIG. On the buy-side, a diverse range of institutions, investment banks and individuals exists. Either they are unable to get quick access to the property market or want to rebalance an existing property portfolio. On the sell-side, there are large property funds that worry about a market downturn and want to reallocate a property investment to bonds or stocks. In other words, sales involve larger volume trades and buys smaller ones.
In 2006, the buy-side was easier to see and to find than the sell-side. Investors were keen to take exposure to the underlying property index, while few investors with physical property exposure were willing to sell. In 2007, the situation has changed. Many investors such as large insurance companies are now concerned about their property investment and willing to hedge, while it is no longer clear who wants to take on the exposure.
For professional real estate investors, derivatives on the IPD All Property Index are a relatively crude tool since these investors often want to express a view on more finely differentiated subsectors, such as retail warehouses or offices in central London. Sector swaps started to bring the market closer to the needs of fund managers. Disaggregation could further play an important role in the property swap market, since the All Property side could feed off growth in the sector trades.
Payday loans to build exposures to different markets
Throughout the 1990s, several other initiatives were launched to get derivatives started. Iain Reid, a property consultant, realized that property funds could benefit hugely from the ability not just to build synthetic exposures to different segments of the market but also to hedge existing long positions by creating off-setting short positions. Reid moved to Barclays and found that its bankers were similarly enthusiastic about his plans to develop a product that could hedge property exposures. The UK real estate market had just been through a crash, and Barclays had property exposure as a result of bad loans made to property developers. To them, the idea that they could hedge that exposure was a revelation and they were very keen to launch something.
Together with Aberdeen Property Investors, Barclays Capital structured a tradable bond that pays out IPD index returns. They called these bonds Property Index Certificates (PICs). PICs link their coupon payments to the IPD All Property Income Return Index and the capital redemption value to the IPD All Property Capital Growth Index. Investors who wanted to gain exposure to the property market paid upfront to buy the bond and received income based on property valuations in the form of quarterly coupon and redemption payments. By issuing PICs, Barclays basically exchanged its long property exposure for a fixed income. The PICs were seen as bond instruments that pay a return based on an IPD index rather than pure derivatives.
The instruments enable investors to bet on the market, but not against it. Since its release, the certificate has mainly created interest from high-net-worth, private bank and institutional investors. In addition, Barclays launched exchange-traded Property Index Forwards (PIFs). These forward contracts on the IPD Capital Growth or Total Return Index included some standardized elements, to make the products tradable. However, in contrast to exchange-traded future contracts, not the market itself but the bank took the role of the market maker. Since the bank never really succeeded in developing a liquid secondary market, the concept was still based on matching buyers and sellers. Barclays continuously quoted prices for the contracts.
Derivatives to manage house credit and price risk
On the side of residential owner-occupied housing, Hinkelmann and Swidler (2006) are sceptic as to whether the market can take off. Mentally, homeowners tend to treat their home just as a consumption good rather than as an investment that involves price risk. Moreover, they would always be subject to a huge tracking error risk when hedging their homes with derivatives based on house price indices. This limits the effectiveness of hedging, and individuals may not use derivatives to manage house price risk. Ultimately, a lack of hedgers in the marketplace may lead to failure of residential housing derivatives such as the Chicago Mercantile Exchange (CME) housing futures contracts. It remains to be seen whether the involved challenges and hurdles can be successfully addressed.
History shows that the buildup period of a new market is very fragile. Property derivatives were launched in the early 1990s and actually failed. The debut on the London Futures and Options Exchange (FOX) crashed in a combination of bad timing and scandal over false trades designed to create the impression of higher activity (see experience in property derivatives).
Today, liquidity in the property derivatives market has a good chance of being increased. In 1981, the first interest rate swap was done. Although people were sceptic at the time, it is now a trillion dollar market. The property market could experience a similar sort of growth in derivative instruments.
Credit generates information about supply and demand
Property derivatives will improve transparency in the real estate market. According to Tsetsekos and Varangis (2000), an active derivatives market plays an important role in facilitating an efficient determination of prices in the underlying spot market by improving transparency on current and future prices. A successful property derivatives market may have several feedback effects on its underlying properties and indices.
Derivatives and their prices generate information about supply and demand of market participants. After the establishment of a derivatives market and due to more and better information, efficiency in the spot market can very well improve. Derivatives make nontransparent prices visible. In particular, the observed derivative prices reveal the market’s expectations. The result could be that market participants anticipate price expectations faster, and nonrandom price moves such as cyclical behavior could partly be washed out. It is important not to confuse true cycles with autocorrelation in an index that may simply arise due to the index construction method. It can be assumed that prices of physical properties adapt faster to new information if there is a derivatives market.
Market participants report loan enquiries
The first French property swap was traded by Merrill Lynch and AXA Real Estate Investment Managers in December 2006. The undisclosed notional amount was linked to the IPD Total Return French Offices Annual Index. By mid 2007, the French market has developed a permanent two-way pricing, i.e. bid and offer prices are constantly quoted. By the end of the fourth quarter of 2007, GB£ 787 million have been transacted in 63 trades. Most trades have been done on the office component of the French IPD index.
Moreover, market participants report enquiries on derivatives relating to the National Institute for Statistics and Economic Studies (INSEE) residential house price index.
The first option on an IPD index outside the UK was traded in January 2007, referenced to the German IPD/DIX Index. Goldman Sachs acted as intermediary for this trade, which was one of the first property derivative transactions in Germany. Subsequently, BNP Paribas offered a capital protected note on a basket consisting of IPD UK All Properties, IPD France Offices and IPD Germany All Properties. IPD publishes official transaction data starting with the second quarter of 2007.
The market picked up quickly, with 44 trades on a total notional value of GB£ 283 million from the second to the fourth quarter of 2007. In May 2007, Deutsche Bank Research expects the German market to reach € 25 billion by 2010. HypoVereinsbank states that a volume of € 150 billion is possible in the long run for Germany and € 300 billion for the European Union.
The numbers represent about 1% of the respective physical property market.
