The property derivatives market experienced a rush of news in the first few weeks of this year: the first commercial property derivatives swap; the launch of the first property derivatives hedge fund; the first property derivative written on a mainland European IPD index; the announcement by CBOT of its plan to offer commercial property futures; and a new UK residential property index that could boost residential property derivatives. It is a sign of the momentum building in this sector.
Property derivatives have been something of a slow burn, with more talk than action for years. But recent trading volumes published by IPD (Investment Property Databank) show that the cumulative notional value of trades in the most active market the UK reached £3.7 billion ($7.3 billion) in the third quarter of 2006. Analysts at Merrill Lynch reckon that a further £4 billion of trading will take place in 2007 to bring the notional value to about £8 billion. It will need to, if it is to support the number of players that are hoping to hitch a ride, and there is still a very long way to go. The Merrill analysts calculate that volumes traded will have to reach £30 billion before the price of underlying property becomes driven by derivatives pricing.
Perhaps the most significant development in the sector has been lost to view. That is the shift in pricing that has occurred over the past three months. The mid-price for the spread over Libor of the December 2010 All Property Total Return Swap has fallen from more than 200 basis points to 30bp. While this reflects a significant increase in Libor over that period, it is also indicative of two things: that the market expects significantly lower growth rates in commercial property for 2007 to 2010; and that there has been significant demand for the short side due in part to lower expected returns on the IPD indices. Shorting has been driven by hedge funds and traditional fund managers wanting to hedge their real estate exposure in anticipation of falling returns.
This may be bad news for direct investors in real estate but it is music to the ears of the property derivatives market. Like any fledgling derivative market, the sector has been hampered by the uniformity of the investor base with everybody wanting to do the same trade at the same time. It was perhaps inevitable that the hedge fund industry would seek to exploit the development of property derivatives sooner or later but the launch of the worlds first property derivatives hedge fund (Orn Capital, backed by Morley Fund Management) is indicative of how much the investor base for these swaps is changing.