New tax rules could help the UK take the lead in the nascent property derivatives market in the second half of 2004.
The rules will treat non-trading profits, gains and losses on some property derivatives as capital gains and losses. So property derivatives that track the value of an underlying property, rather than just rental income derived from it, or total-return derivatives that track both income and capital returns, will get the appropriate tax treatment.
?Users want to match the derivative to the underlying asset,? says Ed Stacey, managing director, derivatives, at Eurohypo AG. ?There has been ambiguity over whether a property derivative would be subject to capital gains tax rules or income tax rules.?
This ambiguity meant tax was not consistently payable by buyers and sellers of protection when a property derivatives contract was settled. Investors in property derivatives didn?t get the necessary tax deductions if they had to pay under the contract.
The UK government announced the changes in its 2004 budget proposals. They will come into effect when the budget receives royal assent in July or August.
Property derivatives are not unknown in the UK. Barclays Capital has launched property index certificates (PICs) based on Investment Property Databank?s all property annual total return index (the IPD index).
But the new tax rules are a key change. ?The asymmetrical tax treatment has stopped people doing trades,? says Phil Nicklin, tax partner at Deloitte & Touche. ?They need to get a good post-tax hedge.?
A viable property derivatives market should make investing in property easier. In November 2002, the Financial Services Authority removed the restrictions on life insurers investing in property derivatives. Life companies account for about 40% of direct investment in the UK commercial property market. But commercial property is an illiquid asset, and transaction and compliance costs are high.
?Investing in property can be time-consuming and tedious, and that militates against rapid trading,? says Simon Yates, a tax lawyer at Hammonds in London. Taking synthetic exposure to UK property would cut costs and could enable life companies to move large sums of money in and out of the market in minutes rather than months.
?There is no difference between buying property derivatives and taking views on the direct market,? says Paul MacNamara, head of property research, at Prudential Property Investment Managers.
Seeking out sub-sectors
Some doubt investors will take sufficiently different views on UK commercial property to make a market. ?If you buy the IPD index you buy an all-property contract,? says MacNamara, who, with other investors, is trying to identify sub-all property markets, such as central London office space or regional shopping centres. ?You might be able to use derivatives on those markets to tactically manage your UK portfolio.?
As well as providing the opportunity to speculate on rises or falls in property prices, property derivatives can be used as a hedge. This makes them useful both to the big property companies and to companies that have significant property exposure but aren?t in the business of managing property, such as some supermarket chains.
?Just as big corporates have their treasury departments that are continuously looking at interest rate exposure, I envisage the big property companies doing the same with this tool,? says Nicklin.
In theory, bespoke derivatives could be written on individual properties. But index-based products will be most common at first, and here the UK has an advantage. Because of the way the UK?s IPD index is calculated and because its constituents represent such a high proportion of commercial property, investors trust it to reflect detailed movements in the property market.
A handful of non-UK index-linked property products are already available. Earlier this year, AXA launched derivatives that track the EPRA European property stock index. ?The Swedish, Dutch, and Irish indices are also probably strong enough to support property derivatives,? says MacNamara.
Building a US market
In the US, Prebon Yamane, the institutional broker, is trying to put together swap products based on the NCREIF total return property index. It is also structuring derivatives based on the Morgan Stanley REIT Index (RMS) and REIT Preferred Index (MSRP), which track the performance of REITs (real estate investment trusts).
?We?ve been working on this for some time,? says Brad Schaeffer, vice-president of real estate derivatives at Prebon Yamane in New Jersey. ?We have a REIT deal in place that is ready to close, subject to some work on the final documentation.?
NCREIF-based derivatives should follow soon. ?You need buyers and sellers, which we have. You need a sound index, which we have. And you need credit,? says Schaeffer. ?On the NCREIF products, we?re in discussions with several underwriters to provide the credit.?
Ultimately, there could be a market for cross-country spreading or swapping of exposures, says Schaeffer. ?If somebody wanted to change their exposures in the UK and the US, they could execute an IPD vs NCREIF spread trade, for example, swapping national returns for immediate portfolio rebalancing.?