Investors have reacted to property derivatives with extreme wariness if not alarm; a recent study points to a lack of familiarity as the cause. Iain Reid reports on a new educational initiative.
The first quarter of 2008 is likely to have seen a record volume of trading in property derivatives in the UK and elsewhere, or certainly close to it. This volume is likely also to have considerably exceeded the volume of trading in the direct property market in the UK. It is now time to review the next steps needed to allow it to grow to full maturity. Part of this challenge is to engage the participation of mainstream property investment professionals and this is taken up by the Property Derivatives Interest Group (PDIG).
In 2003, an independent industry body called the Property Derivatives Users Association was set up by Paul McNamara of PruPIM. Back in 1994, I had initiated and, subsequently, developed a market that used property derivatives to create synthetic property investment instruments, called Property Index Certificates. Paul therefore asked me to join this group, the objective being to persuade the UK regulator, the FSA, to change its view that property derivatives were ‘inadmissible assets' for insurance companies' solvency ratio calculations. With the help of a number of other people, this objective was very quickly achieved and the potential for a property derivatives market effectively opened up. Paul McNamara led the metamorphosis of the PDUA into an interest group under the UK's Investment Property Forum.
PDIG's main aim is to further the development of a broad and deep market in property derivatives. This, by implication, benefits the members of the IPF, who are the professionals of the institutionalised property investment industry in the UK. Although this organisation is predominantly UK-focused it is worth noting that, unlike when it was founded in the 1990s, many of its members are now responsible for the international or global investment strategies of a large number of UK institutions.
Consequently, the expansion of derivatives markets outside the UK is of great interest and importance to them. Accordingly, the membership of PDIG is not only open to individuals who are not members of the IPF but also to those who are active all over the world.
The market has grown from nothing at the end of 2004 to around £14-15bn (€17.7-19bn), in just over three years, comprising more than a thousand trades and involving around 23 licensed banks, as well as a number of broking firms, mainly allied to property consultants. At the last count, over 60% of trades involved ‘end-users', that is institutions or hedge funds. However, the market has been used almost exclusively at the asset allocation level between property and other asset classes. It has, as far as can be ascertained, scarcely - if at all - been used by professional property investment managers in the management of their portfolios.
It is also evident that, while the market has grown rapidly in the UK, it is only at an early stage in most other countries with the partial exception of France, where around £1bn (€1.24bn) of trades has taken place. However, while it is early days, the lights are going on in many countries and trades have taken place in, for example, Australia, the USA, Hong Kong, Japan, Italy and Germany.
This gives PDIG two main challenges. Internationally we must forge closer links with local organisations in other countries and extend PDIG's own activities into continental Europe by the formation of a steering group to run in parallel with that which has been so successful in the UK. The UK group is now chaired by Nick Scarles of Grosvenor and I have undertaken to start the European group. This, we hope, will facilitate communication between market participants in different countries and sharing the experience we have gained in the UK.
The main challenge in the UK is to ‘downstream' the use of derivatives into portfolio management best practice. My last action as chairman of PDIG was to set up a working party under Tony Yu of ING Real Estate to look at the obstacles to this goal. These are partly investment related and partly not. The group will report in the summer and its conclusion will be part of our phase 1 report, to be published in the autumn.
The word ‘derivatives' frequently creates alarm among property investment managers. Securing approval is about the biggest non-investment obstacle. There are a number of concerns about derivatives. These may include: the implications for portfolio performance measurement of the volatility of derivative instruments; the gearing effect of the use of traditional, cashless, derivative instruments such as total return swaps; the alternative of using structured notes, including property index certificates, which are cash instruments; to appraise worth as opposed to price; and perhaps most fundamentally, how to deal with the different timing requirements of the derivatives market compared with the direct market in creating and implementing strategy.
The reality, however, is that they cannot be ignored. For example, in other, liquid, asset classes there is, to all intents and purposes, no arbitrage between the underlying market and the derivatives market. In property, however, as witnessed by price movements over the last two years, there can be a very considerable margin between the ‘spot' (current) value of the index and the pricing of derivatives instruments in any form.
Other benefits include the round-trip transaction costs of the underlying market and the fee savings between derivatives and real property. But from time to time, as has been demonstrated over the last couple of years, it will reflect the immediate outlook for market performance. To achieve the same exposure to property risk will either take an uncertain amount of time, with consequent price uncertainty in the real market, or involve the payment of a premium or realisation of a discount in one or other of the indirect markets.
The ability to understand this, to create a logical and perceptive basis for inter-comparison between different investment media and have the ability to execute accordingly, will be one way in which a property investment manager can outshine his peers in the future. I believe that property derivatives can be the most powerful and, used with full understanding, the least risky of the options that a fully equipped manager can use.
Iain Reid is a member and former chairman of the PDIG and CEO of Protego Real Estate