Euromoney Liquid real estate March 2007
Merrill Lynch and Axa Real Estate Investment Managers’ first French property derivatives swap was most likely a five-year deal with a notional size of substantially more than €20 million, Liquid Real Estate has learned.
The deal, the first continental European swap, carried out in December, was not revolutionary in its structure but its size highlights the market’s increasing breadth.
The trade was based on the Investment Property Data (IPD) France Offices Annual Index. While IPD indices are calculated for almost all global markets, not all are equally robust. “The French index is very suitable for derivatives trades because the index has a good coverage of the overall market,” says Alex Winward, a trader at Merrill Lynch in London. “Most institutional-owned property is externally valued and that gives the market confidence.”
The French market was also a particularly good starting point for European commercial real estate derivatives because of a broad knowledge of derivatives, gained from observing the UK. “We are not starting from scratch in this market,” says Winward. “People in Europe have been monitoring the UK market for the past two years and understand the basic concepts involved.”
Axa Reim began considering a trade in February 2006 but drew back because the pricing on offer was not attractive enough. At the beginning of summer 2006, a number of different banks approached Axa Reim with structures – and pricing – more in line with its expectations. “We began to work out the legal framework a contract would use and the consequences a trade would have,” explains Laurent Lavergne, head of the infrastructure group at Axa Reim.
Axa Reim was working on behalf of a client, whose portfolio of French real estate it managed. “The client wanted to diversify its portfolio,” says Lavergne. “There were two options: either it could sell part of its portfolio and invest the proceeds in another market, such as Germany, while reducing its diversification in France. Or it could do a derivatives trade to reduce its exposure to France while retaining its diversification there and also freeing up funds – as the nominal value of the trade is not exchanged in a derivatives contract – to invest in physical assets elsewhere.”
Understanding the risk
It took some time for Axa Reim’s client to get comfortable with the idea of using a derivative. “The central issue was the degree of correlation between the client’s portfolio and the IPD index,” says Lavergne. “Obviously the IPD index is not a perfect hedge and we – and the client – needed to understand the risks of selling the IPD index and be sure that there was adequate compensation in the spread to account for the risk that entailed.”
Very short-term hedges can run the risk that there is a lag between appraisals and the index reflecting changes, according to Lavergne. “Consequently, our client was interested in a longer maturity trade,” he says. Ultimately, Lavergne believes that 10 years will be the sweet spot for derivatives trades given the investment horizons of most owners of commercial property. “However, it is too soon to go that long in the derivatives market yet,” he says, without revealing the tenor of the deal.
So who was on the other side of the trade? “The range of uses of such a trade is very wide,” says Winward. “For an insurance company with an existing real estate allocation, such a trade allows it to change its asset allocation without getting tied down in the real market. For other types of investors, it offers the opportunity to gain exposure to an extremely attractive market.” Winward says that there was appetite from a wide range of investors: insurance and pension funds, dedicated property funds, high net-worth individuals and private banks and hedge funds are all thought to have taken part in the swap.
Although Merrill Lynch and Axa Reim have not disclosed the geographical location of many of the buyers, it is a safe bet that many were from outside France: real estate investors are eager to improve diversification, which is a real challenge with physical assets. “The benefits of being able to put on a short-term cross border trade are extremely attractive,” says Winward. “Ultimately, we could see a market where people consider their investments in strictly financial terms, with people selling US and buying Japan, for example.”
Lavergne will not be swayed into making predictions about the potential for growth of French real estate derivatives but says that the deal has already stimulated substantial interest among Axa Reim’s clients – and, indeed, generated enquiries from non-clients – interested in both taking and hedging exposure. Winward is less reserved and more bullish. “This trade is just the beginning,” he says. “The commercial real estate market in Europe is vast and so is the potential for derivatives.”
