Performing a mortgage valuation
The introduction of the commercial property derivatives market in the UK has raised some issues related to the valuation process of appraisers (according to the Royal Institution of Chartered Surveyors (RICS)). A sufficiently liquid market of commercial property derivatives would offer useful information about how the market expects property values to evolve. Appraisers could take this information into account when performing a valuation. However, appraisers may pay little attention to derivatives prices in the early stages of the market development.
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.
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.
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.
