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Photo: Property derivatives may become a bigger topic in the trading rooms of banks in the future.

Having established a certain level of comfort on the technicalities of trading, one obstacle that remains is pricing. How should a derivative be valued? ”That depends on whether you are a speculator or a hedger”, says Andrew Baum, CEO of Oxford Property Consultants, an independent advisor. ”Speculators take a direct view on pricing. Which has the greater return expectations – IPD total return or LIBOR? What is the expected cash flow and the risk of that cash flow? A statistical approach is required to address these challenges in forming a view. Now a hedger can take a different view. What are the opportunity costs of using a derivative if you are underweight or overweight in property and wish to close that position? Should a hedger wish to reduce exposure though the use of derivatives, he incurs lower transaction costs than selling in the direct market. In addition, writing a derivative would enable him to retain a property management fee.”

The way forward
Commenting on the role of derivatives in an investment strategy, Rupert Clarke says: ”If the market becomes more established, derivatives should be quicker and cheaper than the direct market. In some cases it might be conceivable that they are used as a substitute for the direct market. For investors that have the infrastructure in place to act in the direct market, derivatives are likely to be used tactically, enabling them to take a position before actually closing the transaction in the direct market.”

The latter point is confirmed by Iain Reid: ”In the past, trading volumes for PICs have been fairly low. Most investors held on to them until they matured. When trading picked up last year some investors bought PICs to sell them after a short period of time. They bought the index certificates against the cash they were holding for investments in real assets or in property funds. When they found the stock they were looking for, they no longer needed the proxy and sold them to get liquidity for the respective property investment.”

Once derivatives trading has fully taken off in the UK market, observers expect it to spread to other parts of Europe. ”This is important as other markets are needed to facilitate cross border swaps”, says Iain Reid. ”One of our principle business drives will be to create derivatives in the Netherlands and a deal may be done this year.” Other potential markets to embrace derivatives are Ireland and Sweden and interest is emerging in France, Germany, Scandinavia and Switzerland. In the US, the investment bank CSFB has been granted an exclusive licence by NCREIF to trade its index, and some deals have been executed.

Many experts are optimistic about the future of property derivatives, with some specialists suggesting trading volumes could reach 3,000 billion British Pounds (4,500 billion Euros) over the next few years. Graham Barnes says: ”In other asset classes derivatives have matured to the same size as the underlying market within three to five years and commercial property has the same potential.”

By Lydia Westrup

Derivates cover a variety of financial instruments that derive their value from an underlying index or security. Over the past twenty years, a variety of derivatives have emerged, among them interest rate and currency derivatives. In the meantime, derivatives have also been developed for real estate assets. These financial instruments allow the investor to manage property risk without having to physically buy or sell the assets. For property derivatives in the UK and Europe, the indices of the Investment Property Databank (IPD) are being used.

Two derivative instruments are currently available, namely Property Index Certificates (PICs) and Total Return Swaps (TRS). PICs are bond-type instruments offering investors a return based on the IPD UK All Property Index. The return includes an income component which reflects the rents. Calculations are based on the IPD UK Annual Index Income Return. At maturity of the bonds the capital return is settled according to the IPD UK Annual Capital Growth Index.

Last year total return swaps (TRS) were introduced. Two cash flows are being exchanged. The receiver of the property collects an index-based property returns. In return, he pays the payer of property a LIBOR-based interest income. The cash flows are calculated on a notional principal amount. The income return is paid annually. Changes in capital values are compounded annually over the life of the TRS and settled at expiry of the contract.