Can property derivatives be viewed as public equity real estate investment, like REITs? Only if they are valued daily, writes Jose Luis Pellicer

Real estate products are typically divided into four categories: private equity, public equity, private debt and public debt. Private equity includes all sorts of unlisted funds (of all risk styles); private debt includes bank and non-bank loans; public debt includes corporate property company bonds and commercial mortgage-backed securities (CMBS), and public equity includes property company shares and (arguably) property derivatives.(1)

Property derivatives are clearly an equity product; their return to investors is based entirely on the performance of a set of properties included in the IPD index. As such, property derivatives pricing is largely based on investor expectations of the IPD total return for a particular year. Similarly, a property company share price is (in theory) largely based on the expected performance and profitability of its property portfolio. In practice, however, real estate investment trust (REIT) prices are largely affected by the general equities market.

It is, however, not so easy to characterise property derivatives as ‘public' or ‘private' equity. Property derivatives are not publicly traded.(2) Yet property derivative prices change on a daily basis, thereby affecting the value of investor holdings in exactly the same way as normal equities. Nevertheless, if property derivatives are held until maturity (that is,  the investor buys a two-year UK all-property note), the return cashed in by the investor will be equal to the performance of the underlying property portfolio minus the spread paid on the property derivatives market at the moment of purchase - just like a property fund.

This makes property derivatives a special form of property equity: if bought and traded, it behaves very much like public equity; if bought and held until maturity, it behaves very much like private equity.

Given the public equity characteristics of property derivatives, it makes sense to think that UK REITs and property derivatives prices evolved in a similar fashion over a certain period - on a monthly basis, for example. If this were not the case, there could be some form of arbitrage available to investors. Let us assume, for argument's sake, that REIT prices fall by 25% over a six-month period, while property derivatives prices remain flat.

This would mean that property analysts' expectations of physical property values included in REIT portfolios have deteriorated consistently over this period, while expectations of the valuation of the properties included in the IPD index have remained flat. This makes little sense. It is very difficult to imagine REIT portfolios deteriorating in value while property funds' and private property companies' portfolios stay put.

Furthermore, many REIT portfolios are actually included in the IPD index, so the index needs to be affected somehow. A smart investor/trader would be wise to expect property derivatives prices to fall quite precipitously under this scenario, and this is precisely what happened in the first six months of 2007.

It is important not to conclude from the above, however, that price evolution of REITs and property derivatives should be identical (or very highly correlated) on a daily basis, given that, first, each instrument is subject to its own short-term supply and demand forces, and, secondly, REIT prices have a tendency to move along with the equities market in the short term. For example, many market operators buy and sell ‘the market', which also includes the main UK REITs.

The arguments above are illustrated in the graph, which compares the evolution of REITs and property derivative prices between the end of 2006 and the end of 2008. The series depicted in the graph are expressed as indices (29 December 2006 = 100). 

Expressing both instruments in comparable format poses some technical challenges. First, the return from buying a REIT share at a given time and selling it at a future time is the percentage difference of both, while property derivatives prices are expressed as an implied future total return. Therefore, something needs to be altered for both to be comparable. The graph expresses property derivative values as an index of the implied total return of a property note that matures in December 2009. We have taken this particular maturity because it coincides with the period of decreased property return expectations and UK economic recession - that is, it captures all the ‘downfall' in the current cycle.

Second, in order to maintain time consistency, while keeping the derivative as a December 2009 instrument, we incorporate the actual IPD index performance as time passes. That is, in the original price series, the December 2009 derivative is expressed as a four-year instrument on the 29 December 2006. However, on 30 June 2007, the quoted rate becomes a three-year instrument. In order to make it consistent with the previous one, we have converted it into a four-year note, but with the 2006 return being the actual IPD index performance for 2006 (that is, 18.1%).

Third, REITs are leveraged instruments (as property companies incur debt). In order to make it comparable, we leverage up the derivative value using the average gearing ratio of the two UK largest REITs and apply a normal weighted average cost of capital (WACC) formula.

The graph compares the evolution of ‘geared 2009 property derivative values' with a share price index of the UK's three largest REITs starting on 29 December 2006. The overall fall in value is virtually the same in both instruments - around 70% on a geared basis since December 2006. Also, there is clearly a lag between REIT and derivative price evolution, with the former taking the lead. But this lag has been decreasing over the period.

Examining the lag issue in more detail, a number of ‘lag periods' can be identified. In period one, from December 2006 to June 2007, derivative values remained flat, while REIT values fell substantially. During that period, a number of bank strategy departments were already advising their clients to underweight in property (that is, REITs), with the advice being duly followed by generalist fund managers. REIT prices therefore began their free fall.

In the derivatives market, the price remained resilient, probably in expectation that the IPD index would still show positive returns in 2007.

Period two coincides with the second half of 2007, when the IPD index shows its first capital value falls and thus derivative values begin to fall dramatically. REITs maintain their free fall in this period, but stabilise in mid-October 2007, while derivatives keep falling until year-end.

Period three is relatively stable, followed by a price fall of REIT prices from March 2008 - this coincides with the fall of Bear Stearns, the first casualty of the credit crunch. This had a domino effect on equities, including UK REITs. Property derivatives reached stability with a time lag of roughly two months and also began to fall two months after JP Morgan acquired Bear Stearns.

Period four starts in September 2008, with the fall of Lehman Brothers. The domino effect is now clear and property derivatives are now moving in line with REITs. Apparently, conversion has been reached.

The graph shows there was a lag, which created arbitrage opportunities for some property hedge fund managers (some of which made returns above 20% in 2007 and far above market in 2008). Yet these opportunities are much less evident right now. But it is still too early to conclude that derivatives have now caught up with REITs and that arbitrage opportunities between both are pretty much gone.

The current co-movement might be due to the recession, which is causing a downward trend in the vast majority of asset prices. Yet the results clearly point towards a historical convergence in REITs and property derivative values, assuming that both markets remain adequately liquid.

It is thus not unreasonable to consider property derivatives in note format as being a form of public equity, provided they are not held until maturity and valued daily.

(1) Referring only to property notes, a subset of property derivatives. In a property note, the investor pays cash in exchange for an exposure to the IPD index. It is a ‘long-only, unleveraged instrument'.
(2) A form of public property derivative is now available on Eurex. These are cash-settled property futures on a notional of £50,000.