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.
The credit and tax bindweed on the growth
In 2004, the authorities loosened the legal and tax bindweed on the growth of a wider derivatives market. One of the earliest derivatives swap was arranged between Deutsche Bank and Eurohypo in 2005, and brought together a buyer and a seller of UK property risk. The seller exchanged a total property return (based on the IPD Index) for a LIBOR-based return paid by the buyer based on a notional principle. Prudential, the UK life assurer, and British Land also agreed on a commercial property swap at about the same time.
The formal launch of the Property Derivatives Interest Group (PDIG) on 16 September 2005 has set the crucial signal for the property market in the UK, which may serve as a role model for property derivatives trading elsewhere. However, the UK is somewhat fortunate because the available indices that are run by IPD are mature and widely accepted as accurate. That is not (yet) the case in most other countries.
In 2006, the market could build on the growth of the previous year and attracted further investment banks. Several banks started to quote option prices on IPD’s main index. Further, it was hoped that the arrival of sectoral transactions would deliver a further boost to the market. However, after a few trades on sector and even subsector indices in 2006, there were no more such deals in the first half of 2007. In essence, it remained a simple swap and forward market on the All Property Index with a few option trades, before trading volume soared in the wake of the US subprime mortgage crisis. The uncertainty introduced by the crisis attracted a number of new participants in the property derivatives market.
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.
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.
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