When performing a mortgage valuation, appraisers prefer using comparable evidence. However, this approach has a number of shortcomings. First of all, it will always be retrospective by definition. Further, the illiquid nature of the physical commercial property market means that transactions are only rarely observed. Moreover, comparable deals may include covenants, incentives and lease clauses that are undisclosed but clearly price relevant and thus distort the comparability.

A forward price curve implied from derivatives could facilitate valuations and increase valuation accuracy by providing market forecasts for rents, yields and capital values on a daily basis. Such forecasts could be incorporated into the valuation process and would provide a timelier indicator than retrospective transaction data. Some appraisers already use derivative prices on the IPD All Property Index and its subsector indices as a starting point for the valuation process. Note that the valuations in turn are used to calculate the IPD indices. In effect, if appraisers follow more closely the forward curve of property prices, the index could follow the prices of the derivatives on them.

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.

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.