It may take some time before the property derivatives sector reaches critical mass. But Will Robson is encouraged by steps being taken and believes it can become an integral part of the industry

After the record monthly falls in UK commercial property values in 2008, prices have continued to slide in the first months of this year at a rate that would seem incredible were it not for the unprecedented falls we have become accustomed to in the past two years.

Some bullish market commentators are encouraged by the deceleration in decline - a "mere" 3% a month in the first months of the year. Gloomier analysts remain cautious, and expect rising tenant defaults and a resultant fall in rental income to cause further harm to total returns. These conflicting views are not surprising given the uncertain outlook for the economy and financial system.

What is clear, however, is that recent events have shown the need to deal with aggressive market movements when holdings are limited to physical property assets. Whatever view property fund managers take on the prospects for the market, derivatives offer a long-needed addition to the toolbox.

So Eurex's announcement of the world's first property derivatives exchange earlier this year is a significant announcement for the sector, hailing yet another encouraging development in a market that could, in the long term, dramatically change investment strategy in commercial property.

Before the introduction of property derivatives, many commercial property fund managers had experience of derivatives, albeit confined mostly to using simple instruments to hedge interest rate and currency risk. These strategies were and are considered so run of the mill that many users probably haven't realised that they are experienced derivatives users.

These strategies involved the use of contracts that allow the buyer to borrow at a certain rate for a given period or to trade foreign currency at a specified price and future time. By doing so, fund managers could protect their investment strategies against the fluctuations in the currency and money markets, which could have a dramatic impact on their future returns if not hedged.

This principle translates directly to the market in property derivatives. These instruments allow the broad movements in property prices (market risk) to be hedged and managed in a way that would not be possible without such instruments.

For the fund manager without a derivatives capability, reducing exposure to commercial property markets generally involves only one option: the sale of physical assets. This can present three problems: high transaction costs; reluctant sales of attractive assets in unattractive markets; and the time-consuming nature of buying and selling.

In markets where an index exists and adequately reflects market returns, market risk could be managed very efficiently through the use of index-based derivatives, allowing investment exposure to be switched between countries and markets, cheaply and easily. 

For those with a derivatives capability, exposure to an underperforming market could be sold down almost instantaneously, while outperforming physical assets in that market could be retained.

Ahead of the downturn in the UK commercial property market, a number of property fund managers sold market exposure through a number of IPD UK All-Property swaps, which allowed exposure to the market to be reduced while retaining ownership of relatively attractive assets. While a physical sale would result in no subsequent cash flows, implementing the strategy using derivatives allows a fund holding outperforming assets to continue producing positive returns through a downturn equal to the portfolio assets' combined alpha.

Critically, a similar strategy can be employed entering as well as exiting the market: investors are able to move into markets quickly where attractive assets are difficult to source. This may be in international markets where the level of local competition is prohibitive or in markets experiencing downturns where prices have yet to correct fully.

In the UK, for example, property funds that are having money allocated to them now may find it difficult to source assets that are sufficiently attractive in their pricing. Unlike equities, due to the heterogeneity and illiquidity of physical real estate, pricing tends to be slow to adjust - especially on the downside.

Because derivatives are essentially forward looking in their nature, expected future falls in the prices of property are incorporated into today's derivative pricing. This means that funds can buy exposure to property today at a future (more attractive) price rather than having to wait on the sidelines. The added bonus for funds seeking to outperform IPD is that although no contract can be guaranteed to provide positive absolute returns, buying a contract in such discounted markets allows guaranteed outperformance of the index on that contract for the period of its tenure.

Aside from attractive individual prospects, the potential impact on the property fund management industry of truly liquid and wide-ranging property derivatives market is fundamental. We have noted how difficult it is to manage market risk with physical assets only. For those without derivatives capability, the performance of their property funds is hostage to the swings in general market pricing. Fund managers can do their best to outperform in a declining market, but can do little to avoid performance being dragged down by deteriorating market sentiment. Derivatives can be used to enter and exit the property market more efficiently, while allowing retention and continued asset management of favoured assets, and these principles apply not only at the ‘all-property' level, but also at the market segment level.

Commercial property investment is an effort-intensive and highly specialised undertaking. To get the best performance out of physical assets, in any market segment, the purchase and sale of assets must be timed carefully around major asset management efforts. Having to buy and sell assets outside these plans to manage market exposure interrupts this effort and is inefficient. With a liquid sector derivatives market, this risk can be managed more effectively to provide enhanced structural outperformance, allowing fund managers to focus more effort on the core role of asset management, which will deliver enhanced stock outperformance.

This potential can be fully achieved only with the development of a fully liquid derivatives market. There are a number of challenges to overcome before the market reaches sufficient scale, not least the fact that perception of the complexity and opacity of derivatives can be a barrier to entry.

One major obstacle remains: the market lacks scale. It is not surprising that growth in trade volume is slowing in the over-the-counter (OTC) market, given the wider market and economic context. It is encouraging to see trades taking place on the Eurex exchange, but in a period of instability in the banking industry it may be some time before the market reaches critical mass. Once this does occur, however - and it surely will - this will have real benefits for direct investors, who will be able to manage the market exposure of their real estate portfolios more efficiently and cheaply.

Of course, the market will still require shrewd investment strategies, incorporating physical and synthetic real estate, and asset managers who can deliver outperformance on stock.

Derivatives, however, will add another tool for investment professionals to deliver and retain value amid the squalls and tempests of the commercial property market. Will Robson is a director of property derivatives at PRUPIM