UK property derivatives are having a renaissance through the interest shown by pension funds and multi-asset managers. Charles Ostroumoff explains
An increase in property derivatives trading by institutional investors, usurping interbank market volumes, is changing the market and the types of product on offer.
For example, on 1 August 2011, Eurex, the world's largest derivatives exchange, launched annual sector index forwards, based on the IPD All Office, IPD All Industrial and IPD All Retail indices. This adds to the IPD UK All Property Index Forward Contract launched in February 2009 when the property market was at its height. These products essentially allow investors to buy or sell (hedge) the future returns of a specific sector (All Retail, All Office or All Industrial) at a pre-defined cost without counterparty risk and without the significant set-up and operational costs associated with swaps.
But who will trade these new products and why? What impact will regulation have and what new products should we expect?
If a fund manager wants to invest in real estate and can source the desired asset, it is inevitable that, assuming no time restraints, they will invest in bricks and mortar over a synthetic product. If the asset is chosen well and purchased at market price, active asset management can increase the value of the building and the fund could outperform the benchmark over time. Moreover, assuming the fund manager has no constraints they have a free option on when to sell that property. The longer the holding period, the less expensive the buying and selling costs as they are amortised over a longer time period. By buying exposure to an annual futures contract, or a string of contracts that essentially track the relevant annual returns of the IPD index, there can be no guaranteed outperformance, unless bought at a discount.
Importantly, returns are crystallised at a fixed maturity or the settlement date. Property futures, therefore, have a limited but specific role - that being to protect short-term returns and enhance performance. If one is trying to buy synthetic exposure for the long term, an investor could continuously ‘roll' the one-year contract on expiry or use other derivative products (such as a fully-funded structured note) which may better mimic the investment returns of direct property investment.
The property futures market is like that of the other futures markets: a short-term risk-management tool. The obvious strategies that the property futures market lends itself to are:
• Liquidity management: to get money into the real estate market quickly and efficiently and to manage redemptions;
• Rebalancing: to enable funds to adjust sector imbalances due to valuations or forecasts;
• Hedging downside risk or balance sheet exposure;
• Overlay strategies: rebalancing or hedging beta, interest rate or inflationary risks.
The Lehman Brothers default highlights the efficacy of the exchange-traded derivatives model. All the on-exchange contracts that Lehman Brothers had open at the time of default were either closed out or auctioned off to other exchange members within a week. The only issues that pervaded after this were to do with reconciliation. PwC is still unearthing Lehmans' over-the-counter (OTC) transactions: the price that was paid or received for the trade; the counterparty they traded with; the notional value and tenor of the trade and any specific requirements. The major regulatory changes being brought about in the US by the Dodd-Frank ruling and in the EU by EMIR and Mifid are primarily aimed at OTC products: to register OTC products on a central repository and to have them cleared through a clearing house. This will mitigate counterparty risk between traders, and minimise systemic risk.
There are many uses for property derivatives. Banks could use them to de-risk their loan books by hedging their real estate exposure. At the customer level, banks could introduce ‘loan assist' products that the customer would purchase as a pre-requisite to a loan. With such products, the bank would be protected in the case that the value of the property was to fall below the loan-to-value level agreed at the outset of the loan. This would positively affect the bank's ability to lend while ensuring the customer was able to receive the loan, given such constraints in the current lending environment.
Private equity funds that have real estate exposure on their balance sheet due to co-investment might want to hedge this risk in the case of an Armageddon scenario. They would run a correlation analysis to see which IPD index best matches the returns of their portfolio and, assuming there is limited basis risk, sell this index to the value of the property exposure on their balance sheet. As property prices go up, the fund is compensated by the value of the funds they have invested in; and if the market were to collapse, they would be compensated through the property derivative hedge.
Property derivatives can be flexible and bespoke. Given that the retail price index (RPI) and UK All Property total returns have been nearly always uncorrelated between 1971 and 2010 (correlation of 0.16), it is possible to create a blended RPI/property linked note with set weightings to both the RPI index and the IPD UK All Property index. In this way, an investor could buy a five-year blended RPI/property linked note with weightings set specifically for these two indices, depending on the position in the property cycle.
Figure 2 shows a 15-year property cycle of solid incremental annual gains followed by two years of dramatic falls before a resumption of annual incremental gains. Given the weak correlation between RPI returns and UK All Property total returns, if an investor loads up on RPI exposure (100%) through a five-year note at the end of the upturn in the property cycle and decreases exposure to real estate (30%) during the same time period, the investor would minimise the damage caused by RPI to their fund while also being underweight real estate at the point of maximum losses through the cycle, helping to minimise the risk and maximise the fund's overall returns. This is a far more effective way of combating the negative effects of inflation rather than overloading on retail property assets that may or may not correlate to RPI, might need extensive asset management and which are priced at a premium due to competition for assets during such times.
The launch of sub-sector products such as city offices, shopping centres, retail warehouses, and industrial south eastern in Q4 11 is eagerly anticipated. Other products could be developed in response to new legislation and accounting rules, such as IAS17. This stipulates that all leases (both financial and operational) should be reflected in the balance sheet. A lease should be reflected as a liability for tenants and an asset by the landlord. This will force tenants to demand shorter leases and increase ERV volatility.
Thus derivative products could develop to protect tenants from future potential increases in rent payable and landlords from potential decreases in rent.
Charles Ostroumoff is a member of the Society for Property Researchers (SPR) and a property derivatives broker with BGC Partners