UK property derivatives: Buying opportunity
‘Exaggerated view’ in property index provides buying opportunity.
With the UK commercial property market still in free fall – IPD’s UK Quarterly Property Index showed an annualized all-property total return for the 12 months to March 31 of –9.7%, the worst in the history of the index, which dates back to 2001, and a –3.3% return for the first quarter of the year – the property derivatives market has gained further credibility as investors seek to hedge their exposure.
UK derivatives trading reached £3.44 billion ($6.75 billion) in notionals for the first quarter of 2008 – more than double the £1.66 billion of notionals traded in the final quarter of 2007 – bringing to a record £9.07 billion the total outstanding notional. The number of trades during the quarter, at 257, also hit a record, confirming that the growth of the market has been far from stifled by the downturn in commercial real estate values.
December 2008 contracts on the IPD UK All Property Annual Index were trading at a total return spread of –11.75% bid/–10.75 offer (spreads have been quoted on a fixed-rate basis rather than a spread over Libor since the beginning of the year) in mid-May, and December 2009 contracts were at –5% bid/–4% offer and December 2010 at –2% bid/–1% offer.
“Implicit in current market pricing is an exaggerated view of the likely misfortunes of the property market,” says Paul McNamara, head of research at Prupim (the property investment arm of M&G Group) in London. He points out that figures from real estate services company CB Richard Ellis show a deceleration of the rate of price decline from a fall of 0.7% in March to a 0.2% fall in April.
In contrast, the December 2008 derivatives contract implies a fall of 16% in values. “There would have to be a substantial re-acceleration in the rate of decline in order for that to be realistic,” says McNamara. “Consequently, for market participants that do not believe that will happen, now should be a real buying opportunity.”
One possible reason why the derivatives market is exaggerating the likely rate of decline in the commercial real estate market is that investment banks, which have carried substantial exposure to the market on their books in a bid to stimulate the market, are now looking to reduce it. “More generally, it must be remembered that property derivatives is still a young market and pricing anomalies are more likely to occur in this period of maturation than they will be in a more established market,” notes McNamara.
Although trading volumes are not broken out for sub-indices such as City of London office space or shopping centres, McNamara says liquidity remains disappointing. “It’s the area that we now need to spend most time on [developing],” he says. “For real estate investors that need to manage specific aspects of their property portfolio – as opposed to generalist investors that have some real estate as part of a broader portfolio of assets – it is vital to be able to hedge or increase exposure to specific asset types. Both property owners and investment banks need to work to better understand how they communicate their requirements in this area.”