Is now the time to embrace property derivatives? Some fund managers avoided the worst of the downturn by hedging the downside risk at the right time. Charles Ostroumoff explains how investors could profit from derivatives in the current market cycle

The UK real estate market averaged returns of 11.1% per annum from 1993 to 2006. It is no coincidence that over this same period the UK enjoyed high GDP growth rates; GDP growth and real estate returns are highly correlated - albeit with a time lag. The credit crunch and the decline in GDP growth rates have brought an abrupt halt to this period of extraordinary returns.

The UK commercial property market has seen capital values decline, almost without precedent in terms of speed and depth over the last 18 months. Over the calendar year 2008, International Property Databank (IPD) figures show that, over the calendar year 2008, capital values fell 26.4%, with 14.4% of this decline occurring in the fourth quarter alone.

Caution and a dramatic fall in the propensity of banks to lend is limiting demand. Supply is gradually increasing as the crisis wears on and bank covenants are being broken, with the double impact of falling capital values and reduced loan to value (LTV) further exacerbating the downward spiral.

While such developments in the direct investment market have led to a marked reduction in the number of deals, the property derivatives market has not been hit nearly so badly. Since the fourth quarter of 2004, over £21bn (€29.1bn) has been traded on IPD indices. While this figure is relatively small when compared with the total amount traded in the direct investment market, it is interesting to note the convergence between the two markets (see chart).

If this convergence were to continue to the point that the total value of trades carried out on IPD Indices were to overtake the total value of trades carried out in the direct market, this milestone would firmly establish property derivatives within the property investment market.

What is causing this convergence? Why is it happening now and what does the future hold for property derivatives? Since their second re-incarnation at the end of 2004, the usage and uptake of property derivatives in the UK has been linear. The inter-dealer brokers and market makers have fostered growing interest and the market has shown healthy growth.

However, due to the high returns investors enjoyed in the direct investment market up until 2006, property derivatives have not been on the radar of property investment companies or property fund managers. Moreover, trading them was seen to be cumbersome with all the associated regulatory documentation and red tape.

Real estate returns show high serial correlation. This explains the lack of sellers in the market place prior to 2007. The credit crunch and financial crisis have combined to cause a dramatic turnaround in the property investment market. While falling capital values make yields more attractive in the direct investment market, the lack of deals and the continued uncertainty in the market have ignited the two-way buy-sell sentiment that derivatives markets thrive on. Hence there is currently greater liquidity in the property derivatives market relative to the direct investment market.

Since February it has been possible to trade futures on the IPD UK All-Property Index, through Eurex, the derivatives exchange platform. This product will complement the existing over-the-counter (OTC) market and encourage new entrants due to the standardisation of the product and low transaction size (£50,000 per contract).

Undoubtedly Eurex's biggest selling point, in these times of exceptional uncertainty and increased regulation, is its clearing facility, which eliminates counterparty risk for both contractual partners.

Products based on sector indices (office, retail and industrial), as well as products based on international indices, will follow according to demand. Such developments could potentially provide the property derivatives market with the catalyst it needs for exponential growth. However, this will not happen without the participation of the large property companies, fund managers and institutions.

One thing the severity of the last 18 months has shown is the importance of having a proactive risk management strategy in place - a strategy that does not just entail offloading properties at knock down prices, but a strategy that protects capital and cash flows. This is undoubtedly the biggest driver for the use of property derivatives.

The property cycle remains intact
Capitalism will survive its latest bout of creative destruction and therefore, by implication, property cycles are here to stay. This does not, however, guarantee the future of all property funds and their managers whom are more bound by Darwin's surviva-of-the-fittest theory than the economics of Schumpeter.

Now that the future can be sold, it is possible to make positive returns even in a period of declining capital values, as witnessed by Iceberg, the real estate hedge fund managed by Reech Alternative Investment Management and CB Richard Ellis, which finished 2008 with a positive return of 5.6%. Capital follows returns. Investors will surely only commit to fund managers that show an investment strategy that delivers returns in both phases of the property cycle.

Strategies for growth
Property derivatives present several opportunities that enable alpha returns. For property funds, like Iceberg, who shorted the real estate market, this has led to strong outperformance of the market.

There were undoubtedly several fund managers who could see the downturn coming but who did not have the remit to short the market or for whom such a strategy was seen as too radical by some of the more traditional investment houses. Now that redemptions have become such an issue, hedging on the downside will surely become more mainstream.

Another strategy to help achieve alpha returns for a real estate fund keen on building up a presence in the direct UK property market is to buy contracts in the futures market. Then as the fund's direct portfolio grows these derivative positions can be unwound. Such a strategy will enable the fund to lock in returns whilst building up a direct portfolio - something that could take a number of years.

It is interesting to note that activity in the use of property derivatives on the Residential Price Index (provided by Radar Logic) in the US has picked up among pension funds and institutional investors over the last six months.

The market is forecast to grow approximately threefold in 2009. If the forecast is correct, this will be one of the fastest growing markets in 2009 - albeit coming from a low base. Although the UK has the largest property derivatives market in the world by volume, the US is usually a lead indicator for the UK in terms of investment trends.

The macro-economic outlook, the lack of liquidity in the direct investment market, the launch of a futures market and rapid growth in the US property derivatives market are all combining to bring further liquidity and growth to the UK property derivatives market. Momentum needs to be sustained, but ultimately the markets will decide.

  Charles Ostroumoff is a real estate investment consultant at Eurex