Property Derivatives

The new darling of the non-correlated investor?

Stuart Fieldhouse
Originally published in the February/March 2006 issue

There is obviously increased interest on the part of funds of hedge funds in emerging strategies: just look at the latest fund launch being planned at Dexion Capital, and you can there is more of a market for extremely non-correlated investment strategies than ever. In addition, some larger and more established global macro managers have been diversifying outside core equity-based strategies in an effort to find better returns (e.g. weather derivatives). This has all led to increasing interest in more esoteric markets, which can still offer managers and investors a fair degree of liquidity.

One such potential 'emerging' asset class is property derivatives. Already an established asset class in its own right, real estate investment constitutes a significant chunk of many institutional portfolios, but direct investment in commercial property is a very long-term game, while many property funds currently on the market are investing in shares in property companies, offering indirect exposure only.

Real estate is one of the last major asset classes in Western markets that lacks some kind of liquid derivatives market, but it has the potential to be both a large and a liquid one. Research carried out by the Property Derivatives Interest Group (PDIG) has suggested that investors controlling over $81bn are already authorised to trade in such a market. However, the volumes tell a different story: only roughly £600m in deals were struck in 2004-05 using derivatives, versus £50bn in direct commercial property transactions. Most of the derivative-based transactions are effected via use of Property Income Certificates, bond structures that first came into use in the 1990s, which pay a return based on the Investment Property Databank index.

Right now there are no standardised contracts: most are executed as bargain trades with pricing determined via negotiations. What are required are intermediaries that are qualified to price contracts, and assume the risk of finding a suitable counterparty.

Historically, there have been efforts to establish a decent secondary market for the real estate sector. In the early 1990s the London Futures & Options Exchange (FOX) launched derivative contracts for property, but came unstuck through a combination of bad timing and a scandal involving the creation of a false impression of high trading activity.

First pure property swap

The reason why there has been more excitement recently is because of the execution of the first pure property swap in 2004, arranged by Deutsche Bank and Eurohypo. The deal brought together a life insurance company and a property firm: the real estate player wanted to take a £40m position in the market, while the insurer was interested in limiting its exposure to possible downturns. No money changed hands – instead the firms settle at the end of each year, with the precise sum determined by an IPD Index.

The appeal for institutional investors seeking more liquid exposure to non-correlated assets is obvious. Most players at the moment are using all-property swaps based on a large and reputable index, but speculation is rife as to whether there will be a demand for more sector-specific swaps – e.g. UK industrial. Structurers are already ahead of the game, however, with capital or income-only swaps under discussion, similar in theory to the separate IO and PO tranches of a CMO bond.

Dutch bank ABN Amro launched the first sector-specific property derivative trade in November last year. In this case, the bank is warehousing some of the risk in the transaction and acting as a true market-maker rather than simply as a broker. The 15-month swap trade comprises £30m in exposure to the IPD All Property Index, and a £30 million exposure to the retail sector.

"This new asset class allows our clients to manage their property exposure precisely, using sector-specific trades, rather than simply trading the All Property UK Index," says Niall Cameron, Head of Global Markets at ABN Amro.

What else is holding back the development of the market, despite its rosy prospects? One is a lack of counterparties: investors in commercial property are known to behave like the veritable herd of wildebeest when spooked. Who is going to be buying when seasoned property investors are looking to sell? The hope is obviously that non-industry investors, like hedge fund managers, would be prepared to take a contrarian view. Andrew Jeyrajah, a property derivatives specialist with Tullett Prebon, says the market is already becoming more liquid. "There are counterparties that are willing to warehouse the risks from these total return swaps," he says. "Banks, property companies, and funds alike are already dedicating resources and manpower to this specific product. These are all-important steps in increasing liquidity."

Rauule Parris, a senior property derivatives trader with ABN Amro, is similarly upbeat. He thinks his bank's sector-specific swap, with its £30m exposure to the UK retail property market specifically, is the shape of things to come. "It was the first time anyone traded a sector," he says, "and it has generated more interest in trading sectors. We are likely to see more interest and liquidity in sectors and sub-sectors going forwards. I think 2006 will demonstrate even more growth, with more market-makers, and more liquidity."

A cornerstone of the development of this market is the wealth of data available on the UK property market, which is tracked in more detail than any other real estate market in Europe. The fact that there is an index available with a long history that is robust enough to act as the underlying for contracts lies at the heart of this market's viability. The IPD series already breaks down into retail, industrial, and office sectors, and as the market grows, traders are expected to reach deeper into the available data resources. It also features a property valuation aspect, and is not all transaction based.

ABN Amro is certainly upbeat. It has already put a dedicated property derivatives team in place, and is actively encouraging other banks to look at the market. Parris compares the current situation to the early days of the credit derivatives market. He says ABN Amro is already in talks about standardising the market, and hopes one day there will even be scope for structured products. "Even in the OTC market you can create a lot of standardisation, as clearing has become more centralised," he says.

Although the time is obviously not yet ripe for hedge funds to consider this market, it is well worth watching. There are still teething problems to be tackled, foremost of which has to be the lack of large counterparties in what could otherwise be an extremely heavily traded market. Perhaps one day there will be the volume to permit dedicated property derivatives funds, and a whole new strategy will be born.