Property companies remain wary of derivatives

US tax change should boost property derivatives

Like any new financial instrument, property derivatives have taken a while to catch on. After a tough second half of 2007, volumes have increased in 2008 on the back of increased usage by institutional investors and hedge funds. Nevertheless, most of the action in property derivatives has been dominated by the UK indices and on the whole the instruments have not been embraced by property owners.

In the second quarter this year, volumes of IPD Property Derivatives traded rose by 42% across the board on the same period in 2007, to £1.88 billion ($3.52 billion). In the three-month period ended June 30, 302 trades were completed, compared with 283 in the first quarter of 2008, the previous high mark.

The bulk of volume came from trading on the UK IPD indices, which accounted for £1.62 billion of the total worldwide volumes. Other markets, notably France and Germany, have been active, albeit on a much lesser scale. In the second quarter, first-time trades were completed in Canada and Spain. Now that a US tax code regarding the taxation of foreign investment has been clarified to exclude derivatives, that market is expected to grow (see US tax change should boost property derivatives, Liquid Real Estate, Issue 07).

Hedge funds, in part, explain the growth in volumes. Dealers and brokers report that hedge funds have been attracted to the instruments. Some are trading opportunistically, and dedicated property hedge funds have used them extensively. In addition, large institutional investors – pension fund managers in particular – have increased their usage of property derivatives to aid in the asset allocation process.

"We are primarily seeing flows in various UK indices from a mixture of institutional and opportunistic investors," says Simon Ziegler, director of global structured rates at Deutsche Bank in London. Deutsche ranked first in global property derivatives in the 2008 Liquid Real Estate poll. Ziegler notes that his team is seeing investors taking both sides of property derivatives trades—the market is not all one-way traffic. Some are bullish, others maintain a bearish stance.

They aren’t used to using much in terms of financial instruments. Using property derivatives can be quite a big step for them Caspar Cook, Merrill Lynch

Real property holders, property funds and Reits have been much less active in the market than hedge funds and institutions. In fact, this end-user group is conspicuous mainly by their absence.

"[Direct property holders’] presence in the market has not grown as quickly as expected," says Cook. "It’s slightly disappointing that they have been slower to see the benefits."

At a time when property values have dropped precipitously, many believed property owners would be attracted to derivatives for their usefulness as a risk management tool. Now that liquidity has returned to the UK IPD indices, end-users’ ability to trade forward prices and therefore forward expectations on property as opposed to the price today has increased. The derivatives market has priced in a drop in capital values over the coming years, giving end-users the chance to take a view on this prediction.

"Clients are able to trade around whether they believe such forward capital values drops are overdone or underdone, rather than having to wait around for the cost of physical property to drop with time to an attractive level," says Deutsche’s Ziegler.

Direct property owners and funds have been hit where it hurts since the credit crunch clamped down on the markets in August 2007. It could be argued that had the prudent use of property derivatives been widespread, some property companies might have been able to mitigate some of the pain. But these instruments were not and are still not part of property companies’ risk management tool kit. A lot of the reason why they are not has to do with market timing.

"Property companies that looked at their overall exposure to real estate and felt that the market was about to turn, as a number did this time last year, could have reduced the size of their portfolio considerably for two to three years through the use of derivatives," says Nick Scarles, group finance director at Grosvenor Group in London. "The reason we haven’t seen trading strategies along those lines is more about market timing than a lack of desire to do it."

The property derivatives market turned in the summer of 2007 in the same way that a lot of other markets turned. If a property company wanted to reduce its exposure to real estate at that time, it would have been giving away about 10% on a one-year forward contract. So, at the time, the cost to reduce exposure through real estate was unattractive. Unless a property company was already in the market, by summer 2007 it was too late to put on a hedge.

Apart from bad timing, there are other reasons why property companies have not jumped into property derivatives. One reason, admit dealers and brokers, is the stigma surrounding derivatives, especially in the wake of numerous derivatives-related debacles and a lack of risk appetite thanks to the sub-prime crisis. As simple as it seems the negative perception of derivatives still held by some clients makes the instruments a tough sell, especially to those not well versed in their benefits, drawbacks and uses.

"Some property investors have relatively limited experience with financial instruments. Using property derivatives can be quite a big step for them," says Merrill’s Cook.

But there are other fundamental reasons why property derivatives aren’t the no-brainer they appear to be, especially for listed property companies. Mark-to-market accounting is a big barrier for some. Listed companies are required to mark to market any derivative positions at year-end and, depending on market conditions, the derivative position will be either in or out of the money.

In theory, a derivative should work in an equal and opposite way to the position it has been put in place to hedge. So when the position is in the money, the derivative is out of the money and vice-versa. The upshot is that, when marked to market, it is possible for a derivative hedge to create a big hole in a company’s balance sheet – a hole that it is difficult to explain away to shareholders.