Property derivatives can be a valuable alternative to direct investment in real estate, but there are timing issues that investors must be aware of when calculating performance. Nick Blakemore reports

Until very recently commercial property was an asset class without an efficient tool for managing market risk - even though it was arguably one with a great need. The illiquid nature of commercial property investments makes it hard to allocate capital when relying solely on trading underlying assets.

For this reason, almost the only option available for property fund managers without a derivatives capability and seeking to protect capital during the last two years was to sell parts of their portfolio. Many property fund managers did sell significant portions of their portfolios ahead of the market falls but this was a lengthy and costly process.

In the latest downturn a handful of the largest institutions were able to hedge portions of their portfolios using index-based commercial property derivatives. Some of these produced double-digit positive returns in a falling market. They were a perfect illustration of potential risk management benefits for institutional investors, and the derivatives market is likely to grow as a result, not least because they will be equally valuable in an upturn.

So property derivatives can be a cost-effective alternative to trading directly in the property market. But some investors expect that they will deliver identical returns to the bricks and mortar equivalent. In fact, volatility in mark-to-market values (MtM) combined with delays in the production of market data required to calculate the swap leg of a trade, result in distorted annual returns being achieved, which can often bear little resemblance to a market sector return.

This is important for investors to be aware of and since it is also complex in the abstract, figure 1 is an example of the implications of this lag in calculating returns. It should not be read as critical of the concept of property derivatives - they are a very valuable financial instrument for the reasons outlined above. But as the use of these derivatives increases, investors should be aware of the potential lag in returns.

An investor enters into a contract to buy (receive) the All Property Total Return on IPD's Annual Index in return for 6.8%. The contract is for two years with exposure commencing 31 December 2006 and has a notional value of £100m.

The reporting and annual calculation of the total return achieved is reliant on two pieces of key data, namely the MtM of the derivative (which can be calculated monthly using data provided by an independent third party) and, second, the annual total return achieved on IPD's All Property Annual Index.

Using live data, the chart details the movement in the MtM over the full period, highlighting the deterioration of property returns towards the end of 2007 as the MtM value attains a price of £72.50 in December, reflecting the price the investor would pay to enter an offsetting contract should they wish to dispose of the contract. Based on the figures above, the movement in the MtM delivers the investor a total return of -27.1% over the first year.

The contract also requires the payment/receipt of the swap leg (6.8% v IPD Annual Index), but publication of IPD's Annual Index for the 2007 year is not available until the end of February of the following year, making it physically impossible to calculate and pay/receive the swap leg of the trade until three months into the 2008 year.

Unable to financially transact the swap leg in 2007, comparables therefore show the derivative achieving -27.1% in the first year, (based on the movement of the MtM only), compared with the IPD Annual Index of -3.4%.

In 2008 (and final year) of the transaction, the MtM continues to account for market conditions, but also takes into account any physical payments. With the publication of the 2007 Annual Index in February 2008, the first payment leg can be computed. This equates to a net payout by the investor of £10.2m (based on the index return of -3.4% vs 6.8%).

Despite the swap leg payment relating to the 2007 year, the MtM has to account for the payment in March 2008 (as highlighted in the graph) and continues to reach a price of £72.87 by December.

As before, the 2008 total return achieved by the derivative will take into account the movement of the MtM (from £72.50 to £72.87), but in addition will take into account the physical payment of the swap leg of £10.2m, which actually related to the 2007
calendar year.

Allowing for the swap payment, the derivative returns -11.9% for the 2008 year compared with IPD's Annual Index return of -22.1%.

Despite the investor acquiring a two-year contract, the swap leg applicable to the 2008 year cannot be paid out until the following year. A MtM is therefore required for part of the third year, at which point there is a complete return to the notional value of £100m.
In 2009, while the contract on the derivative has actually expired, the investor still has to pay out the net swap leg applicable to the 2008 year (-22.1% vs 6.8%) of 28.9% of the notional £100m value. With the MtM rising from £72.87 in December back to the notional price of £100 in March, the investor actually achieves a return of -2.5% due to the swap payment of £28.9m.

Clearly the contract itself was not advantageous in its own right (from a relative return perspective) to the investor. However, more importantly to our consideration here, the returns delivered by the index are materially different to that from the underlying physical, which is due to the delay in payments and different potential for movement in the MtM Value:

Returns actually delivered             2007    2008     2009
Derivative trade                             -27.1%  -11.9%  -2.5%
IPD Annual Index                           -3.4%    -22.1%

Commercial property derivatives give investors the opportunity to manoeuvre fund structures or make calculated bets against other markets in a timely and costly manner. However, the returns achieved cannot be co-ordinated with the financial transactions actually achieved and will therefore result in a reported annual return which will be difficult to compare with a benchmark over any 12-month period.

This is not to say that the value of property derivatives in the future cannot be huge. The emergence of contracts and the potential growth of exchange-traded commercial property derivatives both offer the potential for a significant increase in trading efficiency. They allow property fund managers and investors to invest and disinvest in the market more easily and precisely - but there are timing issues of which investors will want to be aware.