Property Derivatives

Taking property investment to new levels

Originally published in the November 2007 issue

The collapse of the US sub-prime mortgage market has had some unlikely consequences. Northern Rock hovered on the brink of collapse, sparking the first run on a UK retail bank for 140 years yet the equity market has been remarkably resilient, with the FTSE 100 only briefly dipping below 6,000. Most investors are still uncertain whether the credit crunch marks the beginning of a gloomier economic outlook or if it is merely a blip in the continuing good times. One asset class, however, has been particularly spooked by recent events: commercial property.

The past six years have been an extraordinary time for real estate. Buying office buildings and shopping centres used to be the preserve of stuffy pension funds and insurance companies. But in recent years commercial property became sexy. All kinds of investors, from all around the world, were interested in owning bricks and mortar in the UK, whether it be a smart new office building in the City or a shopping centre in the home counties. This wall of capital led to property yields reaching eye-wateringly low levels.

At the start of the year, market commentators forecast that the rising cost of borrowing would lead to a slowdown in the market as higher interest rates and lower yields meant the sums no longer added up for debt investors. That slowdown has been accelerated by the credit crunch. Retail funds investing in property have had to send letters to financial advisers pointing out the declining value of their property portfolios. The Investment Property Databank, which measures the value of commercial property in the UK, said the average total return for UK commercial property hit a 15-year low in August. Even the Bank of England highlighted its concerns over the health of the commercial property sector in its recent Financial Stability Report: “Recent falls in UK commercial property prices and the more persistent falls in yields, along with the potential for overcapacity given a large pipeline of construction, make this sector particularly prone to further shocks and to rises in the cost of finance.”

Iain Reid, Chief Executive of Protego Real Estate Investors and chairman of the PropertyDerivatives Interest Group, says: “The credit crunch exacerbated the problems of the debt buyers. We’re in the middle of re-adjustment which leads to a fall-off in activity while everyone waits to see where prices will settle.”

A market in its infancy

Investors who take sizeable stakes in other financial assets, such as equities or foreign exchange, have access to sophisticated derivative markets to manage their risk. Those who invest in property, however, find it much trickier. There is a property derivatives market but it is in its infancy. The lack of depth in the property derivatives market meant that funds that have significant exposure to commercial real estate found it difficult to completely hedge their portfolios.

Concerns over the impact of the credit crunch on the commercial property market have been clearly reflected in the derivatives market, with pricing turning rapidly over the summer. For example, in mid-April this year, the Dec 2008 UK IPD All Properties contract was at Libor flat but had tumbled to Libor minus 1250 basis points at the time of reporting. Volumes have decreased slightly, falling to £1.66 billion in the third quarter compared with £4 billion in the first half of the year. But some believe that the recent market jitters will, in the longer term, help to boost the number of players and liquidity in the market.

Alex Kinsman, Director in the Derivatives Team at Jones Lang LaSalle, says: “The credit crunch and the downturn in the market have increased the focus on property derivatives. The larger pension funds are gearing up to be able to use this product but it takes time for them to persuade their fund managers and their trustees.”

Property derivatives first came into existence in the mid-1990s when they were invented by Barclays Property Investors and Barclays Capital. The banks were left with property assets after property loans defaulted in the market crash and created the derivatives to hedge against any decrease in the capital value of the property portfolio. UK commercial property derivatives are based on the performance of the Investment Property Databank indices. They tend to come in two forms: swaps and structures known as Property Index Certificates, or PICs, a bond-like structure. The returns of the IPD are typically swapped against Libor plus a spread.

Trading in the derivatives was sporadic until the Investment Property Forum realised these structures allowed investors to get exposure to this market without all of the hassles associated with buying an actual building. And institutions with large portfolios could use these instruments to hedge their portfolios. To create a liquid market, the Property Derivatives Users’ Group, part of the IPF, pushed for a clarification of tax rules to allow institutions to offset capital losses against gains. This happened at the end of 2004 and it marked the real start of market activity.

Opening up opportunities

At the same time, the Financial Services Authority started to allow institutions like life insurance companies to buy, sell and hold these assets. This was seen as a key to getting the market off the ground because it brought the UK’s largest institutional property investors to the market.Over the past few years, it has become easier for investors to be involved in property derivatives as regulatory issues have been gradually ironed out and documentation has been simplified. Mark Daley, a partner at Berwin Leighton Paisner, was involved with the negotiations earlier this year between the IPF’s property derivatives interest group and the International Swaps and Derivatives Association. “Getting agreement on the standard terms for documenting property index swaps was a significant step in the development of the market, and will make it even easier for investors to use property derivatives,” he says.

One of the first documented deals was a £40 million property swap between the FTSE 100 company, British Land, and Prudential Assurance in February 2005. Since then volumes havegrown, with the number of trades picking up sharply. In the first quarter of 2005, there were only 4 trades compared with the 96 trades executed in the third quarter of this year. There is an increasing level of sophistication among investors with a rising number of different players looking at the derivatives market. “In the current climate most investors first think of using property derivatives as a hedging tool as it offers the first opportunity to go short on property. But as the credit crunch has aggressively pulled in prices, more investors might start thinking about using these instruments to go long,” says Kinsman.

Even though it has taken time to educate the more traditional investors, an increasing number of them are grasping the benefits of using property derivatives. Tom Frost, a member of the UK life insurance and pensions team at Deutsche Bank, says: “Some pension fund trustees tell me that they can’t see themselves investing outside of traditional assets such as gilts and equities over the next 20 years. Others, however, understand that they can buy a note or certificate linked to the index and easily get diversified exposure without any of the worries of managing the property or dealing with tenants.

Hedge funds profit from pricing inefficiencies

Hedge funds, in contrast, have had few problems understanding these instruments and their benefits. Unsurprisingly, they use property derivatives to take a view over a much shorter time frame than a pension fund, typically taking exposure for six to 24 months.

“Hedge funds tend to use property derivatives on an ad-hoc basis,” says Frost. For example, some macro funds will think about the relationship between property returns and GDP growth or how real estate performance is linked to interest rates and use property derivatives for these purposes.

And some will use property derivatives to arbitrage. They may think, for example, that the pricing for a particular year relative to another year is incorrect, or that there is inconsistency between different sub-sectors of the market. Through a combination of swaps and options a fund could take advantage of any pricing inefficiencies.

Earlier this year, CB Richard Ellis and Reech AiM launched a property hedge fund called the Iceberg Alternative Real Estate Investment. It currently has $60 million under management but aims to triple these funds by the end of the year. It is a market neutral fund with an annual performance target of Libor +15% with stakeholders ranging from private investors from to real estate companies to fund to funds. Stephen Ashworth, Fund Manager and Partner in Reech AiM, says: “The idea behind the fund is to bring together understanding in derivatives and the world of real estate. There is plenty of inefficiency in the pricing of real estate instruments and the aim is to make money out of those inefficiencies.”

Simply put, the fund looks at the implied valuation of real estate in different instruments then buying the cheap one and selling the expensive one. “It is a classic hedge fund arbitrage strategy but applied for the first time to property,” says Graham Barnes, Senior Director at CBRE Real Estate Finance.

Barnes has been involved in the property derivatives market since its inception. “I remember being terribly excited when we finally had enough pricing information to draw the first curve,” he says. The market has moved on leaps and bounds since then, with depth increasing along with transaction volumes, with several bids and offers at each price.

A promising future

“The market is also becoming more granular,” says Barnes. Investors are becoming increasingly interested in making their trades more specific. “Rather than just trading the UK all property index, they want to trade exposure to specific sub-sectors, like the central London office market or South-East industrials, for example.”

Frost says he is also getting an increasing number of requests for very specific deals from his clients. “Some are even interested in using property derivatives on a specific building,” he says. “Investors are also looking outside of the UK, with volumes on the French and German IPD indices increasingly rapidly,” says Barnes.

Despite the recent market jitters over the credit crunch, both Barnes and Ashworth, believe that the market will continue to increase both its sophistication and the number of participants. Experts predict a growth in more specific sub-sector trades and that there will more property derivatives traded on a wider number of European indices. For Frost, the size of the commercial property market means the growth of derivatives is virtually guaranteed: “In five or ten years we’ll look back and won’t be able to believe that there wasn’t a property derivatives market in 2004. By then, everyone will be trading property exposure like we currently trade inflation or interest rates.”

Residential derivatives

The British obsession with house prices means that everyone from a hedge fund manager to the man on the street has a view whether property prices will be heading up or down in coming months. Until recently, however, it was impossible for a hedge fund manager to take a more concrete view other than using his bonus to go long bricks and mortar in Chelsea and opting for a little geographical diversification by buying a holiday pad in the South of France. But there is now a growing residential derivatives business based on the Halifax House Price index using the non-seasonally adjusted monthly figure. Unlike the IPD, this index reflects capital growth only and the derivatives structure used is a future or contract for difference (CFD). The CFD price is simply the expected future price expressed as percentage of the current level. Deal sizes are also larger than on the commercial property market; a typical sized-trade is about £20-£25 million.

“These instruments are currently being used by investment banks and mortgage lenders as a hedging instrument to manage their loan exposure,” says Michael Levi, Head of Property Derivatives at CB Richard Ellis/GFI. Hedge funds, however, are using them either as part of their view of the UK economy or simply to take exposure to residential house prices. Since the credit crunch, prices have swung from positive to negative, says Levi. “In July, the CFDs pricing levels were around 106107 And they are now 9394,” he says. The volumes have doubled in the last six months as more investors have become wary about house prices falling and have sought to hedge their positions.