Are property derivatives fulfilling their potential? Suppliers and investors must do more, says Simon Redman

Anyone involved in property investment will have been made aware of the property derivatives market, whether through trading or the press, through seminars or attending conferences. No one could accuse the property derivatives industry of being complacent. Its proponents are providing a good insight for people who are mostly unaware of derivatives and their potential applications. The result is that the sector has punched above its weight in terms of profile - but has done so without a significant investment role alongside direct investment or property funds. The volume of derivatives traded is insignificant compared with direct investment.
This does not mean that property derivatives will not become a meaningful part of the property investment market. The question is, in what form and how long it will take. To answer this credibly, the use of derivatives has to be compared with ‘alternative' property investment and the application of property derivatives as an alternative to direct property investment.
The first is as a proxy for direct investment, for example in the form of a derivative contract that provides a return commensurate with an annual property index. This is normally presented as a way of obtaining immediate exposure to property market returns but without the high costs of investing in actual property or the spread associated with most funds.
The second use is to reduce or to short property exposure. Again this is deemed to be a very efficient mechanism, because the ‘seller' is no longer exposed to the market performance of the property market but has not had to suffer the time, risk and expense of actually having to sell assets.
Both of these alternatives appear pretty compelling - the ability to gain or reduce exposure to property market returns without the costs of having to buy or sell actual assets. On this basis it could be expected that property derivatives should become a much more dominant investment option in the future.
However, if one delves a little deeper some of the issues that hinder the development of the market become clear - these include limitations that the asset class imposes, the openness of the property investment market to ‘exotic' instruments and the momentum required to effect change to normal investment practices.
A key hindrance to the development of the property derivatives market is the ability to hedge them. Derivatives written on ‘database' indices such as IPD and NCREIF can only be hedged between investors with opposite views. The obvious example of a more mature derivatives market that works this way is weather derivatives, where no-one can buy the weather - derivative investors have to wait and see what the results are before derivatives contracts are settled. Given recent experience in the property market, which has seen values all going one way (or recently the other), it has been difficult to find property investors with opposing market opinions at the same time. As the UK property market expectations have peaked the volume of derivative trading has reduced significantly because there are presently no buyers in the market. Another impact is that pricing is driven by sentiment on expectations; as the underlying UK property market began to show evidence of weakening last year, the prices of even simple property derivatives became much more volatile. Derivatives based on indices that are trackable (through investing in an underlying fund or property portfolio) do not suffer the same restrictions because these derivatives can be hedged. But, it is difficult to short this index as the underlying is ‘long-only' and two-way trading on these indices is yet to be seen.
These considerations are a world away from traditional property investment. Mainstream property investment managers need to acquire the skills necessary to understand and price property derivatives effectively.
Another factor is that managers are normally paid to be able to outperform the property market and it is questionable whether managers are motivated at all to buy long-only derivatives on a benchmark index that on a net-of-costs basis will, by definition, always underperform the market. Therefore fund managers need to develop a more sophisticated capability to use property derivatives, over and above ‘long-only' trades.
Another restriction on the development of the market is the ability of managers to invest. Most mandates governing property investments either directly or through funds restrict the use of derivatives to hedging interest rate risk and currency risk. Many potential investors are simply unable to make this type of investment without changing the terms of the investment management or advisory agreements and fund prospectus.
Having painted a realistic picture, are there any positives? Areas of progress include the development and growth of indices that are trackable, such as the FTSE Property Index where hedging is possible. Also, an increasing number of managers, especially fund of funds' managers, are becoming experienced in investing in property derivatives alongside direct investments. Furthermore, we are now seeing an increasing number of robust indices for different countries and sectors which will allow managers to show that they can add real investment value by making tactical allocations. Finally, many of the most recently launched funds and investment management mandates allow for investing in property derivatives, which must be a strong signal that property derivatives are here to stay.
Another potential positive is that the property derivatives industry could grow very rapidly if products were promoted to investors already very familiar with derivatives but maybe relatively new to property. This would bring a differentiated source of capital into the property market, with different investment perspectives.
As an industry one of the things that we should do is to produce funds or products that focus on real estate and particularly property derivatives. The ability to create products that employ market-neutral or relative value strategies, more commonly found in portable alpha strategies or hedge funds, has the potential to attract capital that is willing, able and, importantly, capable of understanding how to invest in these sorts of strategies.

Simon Redman is head of business development at Invesco Real Estate