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.
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.
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.
