With volumes reaching record levels despite unprecedented widening in spreads, the end of 2007 and beginning of 2008 might eventually be the period when the market came of age.
Volumes traded in 2007 reached £7.21 billion compared with £3.88 billion in 2006 and there is now £9 billion in notional trades outstanding. Trades in the fourth quarter of 2007 reached £1.662 billion – with 214 contracts being traded, the highest number ever – compared with £1.66 billion in the third quarter, £970 million in the second quarter and £2.72 billion in the first quarter.
“The market has grown significantly,” says Nick Nabarro, spokesman for IPD in London. A total of 22 banks are now licensed to trade real estate derivatives by IPD, with 11 of those licences to trade more than one market – although the UK market still remains the largest – and a further four banks are in talks to gain licences. “There has been a long-term educational push by IPD, banks, brokers and other parties and it happened that the peak of this educational cycle coincided with the sub-prime crisis,” says Nabarro.
Nabarro believes that the market is reaching critical mass – property owners and fund managers are more comfortable with derivatives – just as the potential uses of derivatives are made more obvious by the dramatic changes in the real estate market.
“Prices moved out to incredibly low levels at the start of the year although they are starting to improve now,” notes Martin Francis, director of investment consulting at Atisreal, a property consultancy owned by BNP Paribas.
December 2008 contracts on the IPD UK All Property Annual Index at present trade at a total return spread of around –12% (since the beginning of the year, spreads have been quoted on a fixed-rate basis rather than a spread over Libor in an effort to simplify pricing), while December 2009 contracts trade at around –4%. “Taking into account yields, the December 2008 [contract] implies a fall in capital value of 17%,” says Francis. “That is dramatically more than estimates of around a 12% fall among property analysts.”
However, although there have been substantial flows in the property derivatives market, its shortcomings have also become apparent – sellers vastly outnumber buyers, resulting in extreme volatility and exaggerated repercussions in pricing. “Given the current scale of the market and its stage of development, there is little likelihood of participants with contrary views entering the market in substantial number – there is no depth to the market unlike, for example, the equity markets – so the overcompensation of spreads will continue,” says Francis.
For firms such as Atisreal, which seek to sell risk into the market and hedge their physical asset exposure, this disequilibrium of buyers and sellers makes the market expensive. “It is a relatively inefficient market,” says Francis. Nevertheless, as trading volumes attest, pricing – although expensive – is not prohibitive.
