The main impediment to more widespread use of property derivatives by investors is a lack of familiarity. Tony Yu introduces a new publication from the IPF and PDIG which seeks to address the information gap

The growth of the property derivatives market is yet another illustration of the continuous evolution of property as a financial asset class. Although property derivatives have existed in one form or other since the 1990s in the UK, the emergence of an OTC swaps market on property indices since the middle of this decade, with the participation of a number of banks acting as market makers, has laid the foundations for a liquid and easily tradable property derivatives market of the future.

However, while derivatives based on other markets, varying from equities and bonds to commodities and credit, have grown exponentially (and in some cases have exceeded the size of the underlying market), trading volumes of the property derivatives market have not reached the heights that some commentators expected.

What has been especially unusual and perplexing to some bankers and brokers involved in the market has been the lack of activity by end-users, ie, the actual owners and managers of property. One would have thought that the emergence of a derivatives market on an illiquid asset class such as property, with all the benefits that entails, would be embraced by fund managers of that asset class.

So why have property investors, and especially managers of property portfolios, not been as active in the market as one would have expected or hoped for? The answer to this question is complex. It is partly a cultural issue as property managers are more comfortable managing bricks and mortar than managing financial instruments. It is partly a ‘perception' problem as the use of derivatives incorporates an unjustified impression of invariable risk-taking. And it is partly because of operational barriers that exist within property organisations.

The common theme among all of these barriers is one of education in the property investment management community - indeed, it would be reasonable to say that there is often a fundamental lack of understanding of the concepts, risks, operational issues and possibilities of property derivatives.In response to this, the aim of the IPF PDIG Technical Sub Group's publication, ‘Getting Into Property Derivatives' is to tackle some of those barriers to entry currently encountered by the property investment manager.

As this publication has been written by actual property investors, it is hoped that potential users looking to use property derivatives can use the experiences and perspectives of other property investors to give them guidance on the issues they will have to face. The key principle that should present itself for readers of the publication is that potential users need to understand property derivatives from many angles.

The five important themes that need to be understood are as follows.

Understand the basic concepts
The starting point for any potential user is to understand the basic concepts which are the fundamental building-blocks to understanding property derivatives. What is a property derivative? How does it work? How is it different to other forms of property exposure? How do you appraise it? In particular, the publication focuses on the following:

The instruments - potential users should understand the mechanics of the instruments on offer - not just the total return swap, but also other forms of property derivatives, such as structured notes, which may be more attractive for certain users. Comparisons with other forms of real estate exposure - potential users should understand the differences, advantages and disadvantages of property derivatives when compared with other forms of real estate exposure. Although some investors may see property derivatives as a replacement of more traditional forms of property exposure, the publication highlights some fundamental differences between property derivatives, direct property, indirect property funds and listed REITs that potential users should take into account.  Pricing - users should understand how pricing is quoted in the market, how pricing can be interpreted to create a forward curve of market expectations of returns, and also understand the limitations of such analysis.

Understand the risks

The next step is to understand the risks involved. It is my suspicion that risk is a key hurdle for potential participants - not that potential users fear the risks involved, but rather that they do not know or understand what the risks are. The following are the main risks with property derivatives from a property investor's perspective.

Mark-to-market valuation risks - property investors should understand that mark-to-market valuations of property derivatives are more volatile than the valuations of direct property. The mark-to-market valuation of a property derivative does not just take into account the movement of the underlying index; it also takes into account the change in price of the derivative at the point in time when it is revalued. This in turn is determined by market expectations, which of course can be notoriously volatile. This is not an issue for investors that are not required to mark to market, but investors should be aware of this risk nonetheless. Counterparty risk - this risk is a fundamental difference between property derivatives (especially structured notes) and direct property, and is certainly a key issue in light of the current financial market environment. With a physical property, an investor can take comfort that if the tenant defaults the investor will still own a building that can potentially be re-let to another tenant. With a derivative contract, investors have no such comfort and in the event of a default, future cash flows from the counterparty will have to be written off altogether. Liquidity and pricing - property derivative volumes have grown since inception in 2007, but it would be fair to say that the market remains immature - even in the UK, where volumes have grown the fastest. As such, investors looking to place a relatively large trade in the market should be careful not to move the market price against them unintentionally. This is not to say that the market cannot absorb large trades, and unlike direct property, investors can at least trade the derivative quickly. Quality of the indices - the UK is lucky enough to benefit from IPD indices that are published regularly, have a long track record and are very robust. It is true that there is a valuation lag but investors and analysts can be confident that over a reasonable length of time the index reflects the movement of the underlying market. However, for bespoke indices, and especially some non-UK country indices, this is not necessarily the case. Our report recommends that potential users understand the construction and coverage of the index that they wish to trade on, and ensure that they are getting exposure to what they want. Basis risk - if an investor decides to hedge a portfolio or asset using a property derivative, the performance of the portfolio or asset is unlikely to match the performance of the index upon which the property derivative is based. This is called basis risk, and although some investors may see this as a positive risk if they are able to deliver alpha, it is a risk nonetheless.

 
Understand the possibilities that property derivatives offer

The emergence of the property derivatives market adds a further portfolio management tool into the property portfolio manager's toolbox. Property derivatives not only aid managers with potentially more efficient portfolio management techniques but also open up a whole new range of possibilities and strategies that have not been available to property investors before.

Potential strategies - the publication looks at several strategies that property investors could employ by using property derivatives, from rebalancing portfolio structures and hedging to more sophisticated hedge fund strategies such as arbitrage or relative value strategies within property derivative pricing or between property-related assets and property derivatives. The strategies highlighted in the publication are by no means an exhaustive list but give potential users an illustration of what property derivatives can offer for property portfolio managers. International and sector trading - we have already seen trading on German, French, and US markets and we have seen test trades on Canadian, Italian, Japanese and other country property indices. In addition, we have seen some sector trading in the UK. As the market matures, there is a high probability that we will see growth in international trading and especially sector trading, where one would expect property portfolio managers to have more interest. Specific asset/portfolio trades - to date, the market has focused on index-linked (eg, IPD) trades, but the future could see specific asset or portfolio derivative trades executed. Indeed, this is especially attractive if investors do not like the basis risks involved or do not have confidence in published indices. More property derivative instruments and more possibilities - as the market matures, we would expect further instruments and possibilities for property investors to emerge.

Despite the current difficult economic and property market climate, the derivatives market continues to evolve. In 2008 it was announced that Eurex, one of the world's leading derivatives exchanges, would soon be launching listed futures contracts on IPD indices, and investors should expect further instruments, ideas and possibilities to emerge.

Understand the operational barriers

Some of the key hurdles to market participation from property investors are in the form of operational barriers within investor organisations. This can range from relatively straightforward areas such as seeking and receiving approvals from the end proprietor to execute trades (ie, shareholders, investors, or trustees) to more complex areas such as the negotiation of ISDA agreements.

As a result, the second section of the publication introduces the sub-group's operational ‘toolkit', which is designed to identify the prerequisite regulatory and operational procedures that property investors need to understand before they are able to trade.
The publication demonstrates these hurdles in the form of a flowchart that investors can use as a checklist of areas to be considered. We would offer the caveat that the toolkit should be seen as a guide only, as of course each operational step is dependent upon the internal functions of each organisation. But we hope that this section of the publication gives investors a clear idea of the operational fields that need to be examined if investors want to implement a derivative trade.

Understand how other property investors are using property derivatives

It is always wise for property investors to keep track of what their peers and competitors are doing. The sub-group report allows potential users of property derivatives to do just this, with the third section of the sub-group publication comprising four separate case studies, kindly contributed by members of the sub-group.

The IPF/PDIG Technical Sub Group publication ‘Getting into Property Derivatives' is available on the IPF PDIG website www.propertyderivatives.co.uk and on the IPF website www.ipf.org.uk

Tony Yu is a fund manager at ING Real Estate Select, and is the Chair of the IPF/Property Derivatives Interest Group (IPF PDIG)
Technical Sub Group