How should investors calculate the fair price for property futures? Charles Ostroumoff offers some solutions
Calculating or estimating the value of a real estate asset is a science best expressed by Royal Institution of Chartered Surveyors (RICS) in its Red Book of Valuation Standards. However, there is little in the Red Book by way of estimating future value, and even less in the way of establishing a method to calculate what an investor should pay today to receive the future returns of real estate given the risk profile of the asset class. RICS does not do ‘short-term risk management'. The price that an investor should pay for the future returns of real estate (up to two years forwards) is best expressed in the price of the one or two-year property futures contract as listed on the Eurex Derivatives Exchange.
These are standard index-linked contracts based on the annual total returns of various Investment Property Databank (IPD) indices. Each contract has a nominal size of £50,000 and a par value of 100. The final settlement price will reflect the nominal par value of 100 plus the annual total return for the corresponding IPD UK Annual Property Index during the calculation period of one calendar year.
The final settlement price formula of a property future is:
Final settlement price = 100 * [TRIt / TRI
(t - 1)]
TRIt = Total returns index value at the end of the annual index calculation period
TRI(t - 1) = Total returns index value at the beginning of the annual index calculation period.
Property is a heterogeneous asset class. This makes it cumbersome when trying to make it conform to the efficient-market hypothesis (EMH) and standardised pricing models. Futures markets are essentially based on an agreement to buy or sell a specified quantity of a specified asset on a specified future date at a price agreed today.
The price of a property future is not ‘cleanly' calculated. The real estate practitioner has to be slightly less scientific and more pragmatic when pricing a property future. IPD indices are based on appraisals (which are backwards looking) and this induces a lag into the index. The capital returns of each annual index will essentially be the movement from October the previous year to September of that year. Sentiment from Q4 is reflected in Q1's number. This valuation lag - and due to the fact that you cannot ‘buy' or ‘deliver' the IPD index, since it is physically impossible to replicate - blurs the ‘no arbitrage' relationship used for the theoretical pricing of standard futures when it comes to property futures.
How, therefore, do you calculate the fair price for property futures?
It is essentially a ‘dirty' price. It is important to remember that over the very short term the futures price may not necessarily match the performance of the index, as market sentiment tends to be built into the price more quickly than the lagged valuations-based IPD index, and will therefore be more volatile. However, these will converge at settlement so the performance as indicated by the index is fully reflected in the future's price.
Futures contracts do not always trade at fair price. The market price could be greater or less than fair price due to differing views or weightings of the component parts of pricing by various market participants. It is this variation that makes for a two-way market with buyers and sellers keen to transact at various levels.
Institutional investors give property fund managers equity to invest in the real estate market. In doing so, these investors have made the conscious decision to allocate capital to receive the returns of real estate while accepting the associated risks in the medium to long term. Such an investment strategy leads to one-way investment in the market and a supply-demand disequilibrium that has characterised the property cycle, in general terms, since the second world war - 12 or 13 years of annual incremental gains followed by two years of pain when the market undergoes a correction. Such one-way interest tends to overinflate the market at its peak, precipitating wild investment outflows in the form of redemptions in a downturn, further exacerbating the situation.
An on-exchange sector switch trade will reduce this pricing volatility throughout the cycle. When executing a sector switch, pricing is not nearly as relevant as when you are making a directional trade (long or short). In essence, when you buy one sector and sell another through futures, you are trading the ‘relative difference in value' between the price you enter each sector contract and the price at which they settle.
Exchange-traded sector switches are in their infancy - the first was executed in September 2011. Counterparty A bought the All-Office IPD total returns for 2012 at 102.20, while simultaneously selling All-Industrial IPD total returns for 2012 at 102.00. Counterparty B did the exact opposite.
It is currently possible to execute an on-exchange sector switch at around par. The only cost would be the brokerage fee (up to 50bps or 0.5%). This is comparable to shaking hands with one of your competitors who is over-exposed to a sector you want to hold for the next year and in exchange giving him the returns from a sector in which you yourself are a seller for the coming year.
On settlement of the sector-switch trade, both parties ‘true up' the relative difference in value between the two sectors. These trades can be executed in sizes of £50-100m in one afternoon with none of the associated buying or selling costs of the direct market, and in a regulatory compliant and counterparty risk-free trading environment.
Interest in this product will only increase when futures contracts in the sub-sectors (city offices, West End offices, shopping centres and industrial south east) are listed on the Eurex Exchange in Q2 of this year.
Charles Ostroumoff is a property derivatives broker at BGC Partners