Synthetic real estate – going nowhere fast
For those looking to gain broad exposure to the property market, the attractions of property derivatives are obvious. Instead of having to find physical properties to purchase, the investor simply buys a product whose returns are linked to the performance of an established property index. The cost of buying or selling physical property might be as high as 7% of notional value. The cost of taking the exposure via a property swap is more like 0.5%, and it does not require putting forward any capital at the start of the deal. Also, the economics of a property swap are simple. The buyer agrees to pay a spread over Libor and in return the investment bank originating the swap agrees to pay the annual change in whichever index is being tracked.
Those touting property derivatives also say they have many advantages over property funds and buying the shares of property companies, not least the transparency of the underlying indices used, which are highly visible and follow fixed rules and methodologies. Meanwhile, a property derivative can be tailored to give the buyer whatever maturity they find optimal. Many of these advantages apply equally to retail buyers of structured notes, although they are limited in terms of maturity to what they are offered, and the fees wrapped up in their notes will be higher than the cost of doing a swap.
There are no hard figures for the size of the property derivatives market. The first pure property swaps started to trade around 2005. Morgan Stanley estimated that by November 2007 the UK commercial property derivatives market had a notional value of about £10 billion ($20 billion), with the residential market in the £1 billion to £2 billion range. Morgan Stanley estimated that the French and German markets taken together represent about £1 billion to £2 billion in notional value, with the US market sitting at around the £1 billion level.
Since the first property swaps were traded, property derivatives have attracted a lot of attention from life insurance companies and property funds as well as, dealers say, from some pension funds, hedge funds and corporates. An insurance company, for example, might use the swaps market to gain diversification or make cross-border investments, while a property fund could use property swaps to take relatively liquid, long positions in property. A property company could use them as a risk management tool, and hedge funds as a speculation tool.
