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Real estate investors seek to diversify their portfolios. As part of this process they are putting new markets and vehicles on their investment agenda. One tool still missing on the real estate investment menu is property derivatives.


Photo: Graham Barnes, Senior Director at CB Richard Ellis Financial Services

Photo: Andrew Baum, CEO of Oxford Property Consultants

Photo: Rupert Clarke, Head of Real Estate at Hermes Investment Management

Photo: Iain Reid, CEO of Protego Real Estate Investors

For more than a decade, attempts to create a functioning derivatives market have been made, but success has been patchy. This could change now. Currently two types of contracts are being offered: Property Index Certificates (PICs) and Total Return Swaps (TRS). ”Economically, both instruments achieve the same purpose: an index-based property return. However, PICs are funded instruments, this means the seller of property receives capital, while a TRS is an unfunded instrument”, explains Iain Reid, CEO of Protego Real Estate Investors and an expert on property derivatives. Since 1994 he and his management team have originated derivative transactions of around 2 billion British Pounds (3 billion Euros).

UK derivatives shifted into growth mode
In the UK, derivatives shifted into growth mode last year. The market was given a boost in late 2004 when some legislative changes were made. First, the tax position was clarified and derivatives are now treated in the same way as direct investments. Second, the Financial Service Authority allowed insurance companies to hold derivatives for solvency ratio purposes. This spurred a general interest by potential participants, but it did not lead to increased trading volumes.

To combat the apathy, Hermes Investment Management, a UK fund manager known for its financial acumen, initiated a trading simulation based on real market data last year. Rupert Clarke, Head of Real Estate at Hermes, explains the reasons: ”Though we were interested in trading derivatives in principle, there was no real urgency for us to do so since we are capable to meet our objectives without the use of derivatives. This, coupled with the uncertainty as to whether a market would indeed develop, made us hesitate to commit the time and the manpower needed to fully understand how derivatives might work. We then decided to look for ways which might help us to feel more comfortable using the instruments. Hence, we developed the idea of the trading game, and we invited other potential players to join us.” Many important players in the UK property world beckoned Hermes’ call and about 60 participating parties, among them institutions, property companies, investment banks and derivative specialists, traded based on their market perception. Three trading sessions were spread over a period of nine months. They were accompanied by lectures explaining the trading fundamentals and practicalities as well as the back office arrangements. ”As part of the process we have been encouraging the participants to get their approval procedures and back office arrangements in place so they can actually trade should they wish to”, says Rupert Clarke.

Viele, die in der britischen Immobilienwelt einen Namen haben, folgten dem Aufruf von Hermes, so dass rund 60 Personen, darunter Vertreter von institutionellen Investoren, Immobiliengesellschaften und Investmentbanken sowie Spezialisten für Derivate, an dem virtuellen Handel teilnahmen und auf der Basis ihrer Markteinschätzung Derivatkontrakte handelten. Über einen Zeitraum von neun Monaten wurden drei Handelssitzungen abgehalten. Diese wurden ergänzt durch Referate über Grundlagen und Durchführung des Handels sowie Fragen der Abwicklung.

And the work is bearing fruit. According to experts in the UK, derivative contracts with a nominal value of around 1 billion British Pounds were executed last year. Graham Barnes, Senior Director at CB Richard Ellis Financial Services, is confident that a significant number of large UK and international institutions will enter the market any time soon: ”We estimate that institutional involvement will increase during the course of this year. As and when this happens, growth in the market could be exponential.” His views are confirmed by a survey conducted among property owners. A group of investors with collective assets worth 27 billion British Pounds (40 billion Euros) is geared up and willing to actively use derivatives.

To facilitate trading IPD has licensed around a dozen banks to trade on its indices. Licence fees are calculated at a staggered amount. They accrue only when a deal has been done. The licence is non-exclusive and terms are the same for any licensee. Not only real estate owners and investment banks are getting ready to trade, international derivative brokers are preparing to do business in Europe. GFI, a leading broker of derivatives in the US, teamed up with CB Richard Ellis to assist in developing the property derivatives market in Europe. ICAP joined forces with Grafton Advisors, and Tullett Prebon co-operates with DTZ in marketing and executing property derivative contracts in the UK and other European markets.

Initially, derivatives were based on the IPD UK All Property Index, but increasingly other contracts are being introduced. ”We have started trading individual sectors against the main index, as well as one sector against another. As for maturities, periods vary from nine months through to ten years. Given the current interest we, expect a greater range of interest coming in all the time”, says Graham Barnes. Trades typically range between 10-15 million British Pounds (13-20 million Euros), but market observers anticipate the lot sizes to increase with the introduction of more institutional interest.

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