Increasing volatility of credit
Derivatives reflect the market’s sentiment and expectation quickly in their prices. Improved understanding and transparency could foster the acceptance of real estate as an asset class. Further, derivative markets should provide accurate signals for an optimal allocation of capital and risk.
Higher attractiveness and better risk management possibilities due to property derivatives could drive property prices generally upward. In other words, the risk premium and accordingly the cost of capital shrinks, since risk can better be measured and managed. However, this will only occur when there is enough liquidity and risk management opportunities. The investment bank Merrill Lynch estimates that this scenario can begin to happen if derivative volumes traded reach at least the transaction value of direct property. The bank estimates the critical size in the UK to be GB £50 billion turnover per year for the commercial sector. With the rapid growth of the UK property derivatives market, such a feedback effect could soon be seen to start.
Another feedback effect concerns activity. Experts say that the introduction of a derivatives market potentially reduces trading volume in the spot market, since the transfer of risk and return through derivatives make physical transaction at least partly obsolete. However, evidence is mixed. Other studies show that the existence of derivatives have actually improved activity in the related spot market.
However, there is some concern that a successful derivatives market will lead to fewer transactions in the underlying property market, reducing the base market’s liquidity and increasing credit volatility. This may have a significant impact on the underlying indices used to measure property returns, particularly the capital growth indices, which rely on valuations based on transactional evidence. Derivative advocates argue that there will always be demand for physical property from investors who believe they can beat the market through picking individual properties and actively managing them.
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.
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.
Cash-settled payday loan contracts are available
After the launch of futures and options on regional home prices, CME announced a partnership with the commercial real estate index provider Global Real Analytics (GRA) on 6 September 2006. They listed future and option contracts based on the S&P/GRA Commercial Real Estate Indices (CREX) on 29 October 2007.
The S&P/GRA CREX indices capture underlying real estate dynamics by tracking transaction-based price changes in diverse property sectors and geographic regions. GRA has a 20-year history of capturing data and sees the new indices as a natural extension, suited for the use of publicly traded futures contracts.
Ten quarterly cash-settled contracts are available: a national composite index, five regional indices (Desert Mountain West, Mid-Atlantic South, Northeast, Midwest and Pacific West) and four national property type indices (retail, office, apartment and warehouse properties).
CME expects the users of the new property contracts to be different from those trading in housing derivatives. If someone hedges against house-price declines in an area, he or she develops or buys a house there. The commercial contracts, on the other hand, are designed for larger investors who hold commercial properties in their portfolios, such as pension funds and REITs.
To hedge real estate or home price declines, individuals can purchase put options based on a particular index. If prices fall, investors will naturally see the value of their real estate holdings decline, but they offset the losses with gains in the put options. The CME hopes that there will be enough speculators in the market to take the other side of the transactions.
