It is possible to make a credit funded investment
Alternatively to an unfunded swap or CFD, it is also possible to make a funded investment. Rather than paying LIBOR plus a spread quarterly and receiving property returns, the investor pays the notional amount of cash upfront and receives property returns net of the spread. For example, on a two-year swap an investor could choose, rather than paying LIBOR plus 1% on the swap, to pay 100% of the notional amount and receive the property return minus 1% each year and 100% redemption after two years.
The basis for property derivatives documentation is the International Swaps and Derivatives Association (ISDA) documentation. Just as for other derivatives, ISDA has prepared standardized documents for property swaps, in order to facilitate trading. The Property Index Derivatives Definitions were published in May 2007. Standardization aims to reduce transaction costs, legal risk and transaction time, to increase transparency and confidence in the market, and to improve efficiency and liquidity. In addition to the definitions, ISDA provides confirmation templates for forwards and swaps in the US (Form X) and in Europe (Form Y), as well as an annex that describes the indices on which the trades are based. By September 2007, the Association has included the Standard&Poor’s/Case–Shiller Index, the Office of Federal Housing Enterprise Oversight (OFHEO) Index, the National Council of Real Estate Investment Fiduciaries (NCREIF) Index, the worldwide Investment Property Databank (IPD) Indices, the UK Halifax House Price Index, the FTSE UK Commercial Property Index and Radar Logic’s Residential Property Index (RPX). The definitions booklet covers issues such as disruption events on these indices. More indices, as well as confirmation templates for options and basket trades, are likely to follow.
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.
Development of the property credit and taxes
The development of the property derivatives market has so far centered on the UK and the US. However, both interest and transaction volumes are growing throughout Europe and Asia. Market participants expect first trades in Denmark, Ireland, the Netherlands, Spain and Sweden after first trades in Australia, France, Germany, Hong Kong, Japan and Switzerland. As the quality of indices improve, more and more countries will see first trades. Also, thePan-European IPD index creates strong interest from retail investors and from US pension funds. The trend is unlikely to spread to some countries where the data basis, needed to construct a reliable index, is insufficient.
Quickly increasing volumes are also expected due to the interest of insurance companies to hedge their liability risk, which depends heavily on real estate price changes. Liquidity will probably only change if more banks are willing to warehouse risks, i.e. take a risky position.
More mature markets will lead to more standardized derivatives traded on exchanges. However, the OTC market is likely to be the dominant derivative format in the near future.
The property group Grosvenor and ABN Amro traded the first property derivative in Australia, based on the Property Council/IPD Australian Property Index, in May 2007. The trade took the form of a two-year total return swap.
