Euromoney Liquid real estate March 2007
Derivatives back with a bang
Real estate derivatives volumes have finally taken off and there is still plenty of scope for further growth. The UK is leading the way but the European, Asian and US markets are picking up too. Laurence Neville reports.
20 years behind the mainstream
Making the difficult move into residential
The ingenuity of financial markets should never be underestimated: more than 15 years after the demise of the London Futures and Options Exchange property futures contracts in 1991, the real estate derivatives market is back with a vengeance, in a variety of forms; market participants speak optimistically of real estate derivatives as being “the next credit default swap market”.
Although the market is still dwarfed by physical sales – around £15 billion was invested in central London office property in 2006 – derivatives volumes have grown at an incredible pace: Investment Property Data (IPD) recorded £1.1 billion of trades from the beginning of the market to the end of 2005. By the end of 2006, a notional total of £4.675 billion of trades had occurred. Moreover, brokers say interest in the market has exploded with them fielding dozens of calls a day from interested parties.
While much activity remains focused on the UK All Property total return swap market, the market is deepening with attention focusing on discrete market sectors such as retail property. Merrill Lynch and ING Real Estate sold the first bond linked to the IPD Central London Office index in January. Then, at the end of February, ABN Amro executed the UK’s first industrial sector swap, taking a £10 million position.
At the same time, the derivatives market is expanding outside the UK. In December 2006, Merrill Lynch and Axa Real Estate Investment Managers announced that they had executed the first French property derivatives swap trade linked to the IPD France Offices Annual Index (see Deal Architect, Anthracite breaks new ground in Europe) while at the end of February, ABN Amro and Sun Hung Kai Financial announced the first ever Asian property derivative based upon Hong Kong residential properties (see Virtual real estate hits Asia).
Transparency is also improving. In February, derivatives broker CB Richard Ellis-GFI launched an online service to track prices. And, as the number of brokers and investment banks in the market has soared – 15 investment banks now have licences to trade real estate derivatives and around half of those make markets on a daily basis – so liquidity has increased: bid/offer spreads of UK All Property Index have come down from as much as 100 basis points a year ago to less than 30 basis points now.
Meanwhile, across the Atlantic, the market is developing in a different way (see news story on page 20). In March 2006, the Chicago Mercantile Exchange (CME) launched futures and options based on 10 residential housing markets in the US as well as a composite index. Its erstwhile rival, now turned merger partner, the Chicago Board of Trade (CBoT), launched a futures contract based on the Dow Jones US Real Estate Index, which references a number of real estate investment trusts and other property company stocks, at the end of February. Further competition is on the way: trading based on the National Council of Estate Investment Fiduciaries (NCREIF) Property Indices is expected to begin as soon as April.
Why get involved?
The main attraction of real estate derivatives versus the physical market is the former’s speed of transaction, liquidity, ability to leverage, low cost and diversification. Buying a total return swap, the mainstay of the market, allows an investor to gain immediate exposure to the UK commercial property market for a specified time period for just a small payment – avoiding the months-long process of sourcing physical assets. At the same time, investors retain the flexibility of exiting their investment early if required, although the vast majority of trades are held to maturity.
The buyers of such exposure could range from pensions funds and insurance companies to dedicated property companies with cash on their books and an absence of locations in which to invest in physical assets. “To date, we’ve used swaps as part of the asset allocation process,” explains Paul McNamara, head of property research at Prudential Property Investment Managers (Prupim) in London. More generally, the freedom from 4% stamp duty – paid on physical assets worth over £500,000 – is a draw.
The growth of the market has, to some extent, been aided by the wide investment experience of many real estate market participants. “For the majority of potential buyers, derivatives are not an alien concept,” says Alex Dewey, property derivatives manager at brokers Cushman & Wakefield in London. “Large pension funds, for example, will already be familiar with derivatives from the FX, equity and interest rate market and will already have specialist teams in place analysing and trading them. It is an easy move to apply those skills to real estate.”
For a seller, a total return swap offers a way to reduce exposure to the market – or to a particular sector – without selling the physical property assets: a process that costs around 7%, including surveyor, estate agent and legal costs and stamp duty, and which many investors are reluctant to do given the limited availability of properties and the consequent difficulty in re-entering the market. “We have had situations where a number of UK life funds were shrinking in size and consequently had become overweight property,” says Ed Stacey, managing director, derivatives at Eurohypo in London. “But they didn’t want to sell because commercial property was outperforming and a swap made perfect sense for them.”
While banks and institutional investors have been the driving force in the market to date, almost all market participants speak wistfully of the future arrival en masse of hedge funds. “The arrival of hedge funds will be a significant spur to liquidity,” says McNamara. “The market is already off the ground, but hedge fund involvement could propel it into a different league overnight.” Orn Capital, a hedge fund owned by Morley Fund Management, announced in January of this year that it was launching what it billed as the world’s first property derivatives fund (see news section on page 18).
Meanwhile, the other vital group for a successful market – traditional property investors – are slowly coming round to the benefits of derivatives. “A number of the more traditional investors have said to us in the past: ‘Why would we want to reduce our exposure to property? That’s what we do for a living.’ But that attitude is rare now,” says one London-based broker. “Most people appreciate the benefits of involvement in the market now and the volume of enquires we have had is phenomenal.” More generally, it is expected that the average maturity of swaps will lengthen over time as the more traditional property investors – which have a longer investment horizon – increase their involvement, says Dewey.
Important notes
While total return swaps have come to dominate the market, property income certificates (PICs), which were first issued by Barclays in 1994, have been important in real estate derivatives gaining acceptance. Investors in these bond-like notes, which are based on total return swaps, pay a notional upfront and receive a coupon based on the IPD index with the principal, adjusted for changes in the index, repaid at maturity. Most bonds sold have maturities of less than three years and, unlike swaps, PICs can be sold on.
“Buyers use PICs both for long-term exposure to real estate and as a shorter term hedge against cash holding,” explains Iain Reid, chief executive at Protego Real Estate, which works with Barclays to develop and sell PICs. Their main advantage over total return swaps is that they are structured as a Eurobond and reference Barclays’ rating – a huge advantage in terms of the potential audience of investors. Although Barclays and Protego do not reveal where they source their exposure from, it is widely believed that they have conducted total return swaps with life insurance companies.
The success of Merrill Lynch and ING Real Estate PIC-like issues linked to the IPD Central London Office index in January is expected to spur greater appetite for sector exposure among investors. “We expect to see investors using these instruments to make sector trades,” says Reid. “It’s an easy way to adjust allocations in the short term.”
Accurate indicator
Derivative spreads should be an accurate indicator of investors’ expectations of price movements in the physical commercial property market: if people are prepared to pay a higher rate over Libor, it should indicate that the market believes property prices will rise; as spreads come down, the market is assuming prices will drop. Alex Winward, a trader at Merrill Lynch in London, believes that this is occurring. “The yield curve shows that after 2007, there is an expectation of lower pricing, which is exactly what analysts expect,” he says.
Property derivatives spreads have fallen since summer 2006 from 200-280 basis points to as little as 20-50bp for a December 2011 contract. What has driven this tightening? “In the summer, there was huge confidence in the returns from property over the remainder of the year and this was borne out by subsequent returns,” notes Nick Mansley, property strategy and indirect investment director at investment house Morley in London. The IPD Monthly Index delivered a total return of nearly 14% between March and the end of January compared with around 4% for cash (the other leg of the swap transaction) respectively. “For a December 2011 contract this alone would explain a nearly 200bp fall from the spreads available last April and a 100bp fall from the spreads available in the summer,” he says.
Secondly, interest rates have increased considerably over recent months – the five-year swap rate is over 5.6% compared with less than 5% in the early summer last year and around 5%-5.25% for much of the second half of 2006. “Hence, again for the same view of property returns for 2007-11, one would expect spreads to have fallen by around 50% since the autumn,” says Mansley.
Nevertheless, there remain suspicions that given the limited turnover of the real estate derivatives market, spread movement may not be wholly reflective of the underlying. As Cushman & Wakefield’s Dewey notes, while the swap curve should generally move towards the cost of borrowing plus friction costs, the inability to effectively hedge the index through the physical market – as one can in the equity market – can distort spreads. “This creates a problem for the banks making markets, as the market is too small for them to hedge their positions,” he says.
Options to come
Market participants believe that real estate derivatives gained critical mass in the UK in 2006 and expect 2007 to be a year of innovation and increased confidence. But what form will that innovation take?
Most observers believe the obvious next step for the market is the development of a futures and options market. “The options market will come but not until the swaps market is more liquid,” says Merrill Lynch’s Winward. “We are probably six to 12 months away.” More generally, the range of products available will inevitably increase. “We are likely to see more swaps based only on capital appreciation and portfolios based on specific sector or sub-sectors,” he says.
The other big growth area for real estate derivatives will be international markets. “We would love to be able to use overseas property derivatives,” says Prupim’s McNamara. “If you have £50 million to allocate to Sweden it is far better to buy the whole market than two assets. However, in order to do this we require more frequent interim updates of the index than the current annual measure. We need to know whether we are up or down throughout the year.” As Cushman & Wakefield’s Dewey notes, investors are increasingly looking to invest in the emerging markets, for example India and China. Real estate derivatives could, in the medium term, allow investors to do this, although it will be dependant on the robustness of the underlying indices.
Following the trade in France by Axa and Merrill Lynch, there are expectations of trades in Ireland, France, Sweden and Holland within the next 12 months. However, Germany – Europe’s largest market – is likely to take longer to develop. “Confidence is lacking in historic valuations in Germany,” says Morley’s Mansley. “There remains a question across Europe about how the market will develop,” confirms Dewey. “There remains a question relating to the valuation of the underlying. However, the increase of investment into Europe may see a move toward the UK model of valuation.”
Meanwhile, the physical commercial real estate market – which has provided a backdrop of boom conditions for the growth in the derivatives market – is widely expected to slow, or even fall, this year. “The obvious benefit of the derivatives market is that it makes it possible to make money out of a falling real estate market,” says Dewey.
“If anything, an increase in property yields could boost volumes as people seek to protect themselves from a downturn in the market.” Winward agrees: “If the underlying market stumbles, then there would be an adjustment in price,” he says. “It wouldn’t mean that brokers
wouldn’t transact or that banks wouldn’t be prepared to warehouse risk.”
