A slow build
After a stellar start, the German property derivatives market looks in danger of slipping into obscurity. The largest real estate market in Europe barely features as a derivative market, and quarterly activity is falling while it rises elsewhere. Until brokers can be tempted back to market making, liquidity will remain low and volumes capped. Owen Wild reports.
The European property market had been on an upward curve until mid-2007. This continued pattern of appreciation might not have been considered helpful for the development of a property derivatives market but the growth in volumes over the year in the UK showed this was not the case. Similarly the French derivatives market, which opened in early 2007, has seen good early volumes, but in Germany progress has been less dramatic.
The German real estate market is the largest in Europe, but it has been stagnant for a number of years. Valuations for commercial and residential property have failed to grow at a similar rate to that of France and the UK. This should mean that German property is relatively good value, but that is not sufficient to drive derivative volume.
"Germany has catch-up potential as there was essentially stagnation in Germany over the past five to seven years," said Daniel Piazolo, managing director at IPD in Germany. "But volatility is good for derivatives. If there is stability it is good for cross market trades, but not those based on just one index. In the UK derivatives had a boom as UK real estate values boomed and then were expected to drop considerably."
In the past 11 years German real estate has never shown an annual total return of above 5.5%. In 2005 growth was just 0.5% and 2006 saw only 1.3% gains. In the same period the UK has seen annual returns of up to 18%. The post-unification enthusiasm simply didn't last in Germany, but many expect the economy to perform better than European neighbours over the next decade and this should feed through into the property market.
Yet today the picture for the derivatives market is much less positive, despite an initial flurry of interest. The UK property derivatives market launched in 2004 and by the start of 2007 was a substantial business, but was limited to swaps based on the monthly index produced by IPD. The German market was the first to emerge in continental Europe, coming ahead of France, and the first trade was also a milestone as it marked the first option written in Europe.
The trade was completed by Goldman Sachs against the DIX commercial property index. Market watchers were encouraged that there had been such a trade written, suggesting that this was most suitable as the index is published annually and therefore a right rather than an obligation would be preferred.
There are different views as to why this launch did not lead to significantly greater volumes. The biggest gulf is between the perception of the dealers of the index and those of the producer IPD.
The German market is without question failing compared to the UK and France, even though volumes fell during the year in these markets. It took time for Germany to get going with a peak in activity in the second quarter of 2007 (see table). The volumes also show how both French and German activity has reduced in terms of notional.
"The UK index is monthly," said IPD's Piazolo. "It is a regular update that makes it easier to estimate what annual changes might be. In Germany and France it is just annual and by the fourth quarter there has been no data for eight or nine months, so it is quite remarkable there is any activity at that point."
Others agree that until there is an improved platform of data capture and distribution for the property market in Germany a derivative market simply cannot develop, and that means not just a more frequent index but also REITs.
"Germany is a conservative market for financial development and always has been, as shown by the lack of an ABS market and the slow development of the REIT market," said Norbert Schulte, corporate and real estate partner at McDermott Will & Emery. "But the development of a derivatives market is dependent on a number of REIT flotations as there is a need for more comprehensive and frequent data about the performance of the real estate market than an index that is published once a year."
IPD hopes to move to quarterly publication but that is unlikely to happen until during 2009. Others suggest that the segmented nature of the real estate market in Germany also means that a German index would be of little value to most investors who would prefer regional breakdowns, but that is unlikely to be possible in even the next 12 months.
Yet the data shows that in France, while the average size of deals fell through the year, the number of trades each quarter remained steady despite being an annual index.
One broker said that the dramatic falls in Germany were therefore for different reasons, primarily a lack of faith in the index and a fall in the number of houses willing to act as market makers in recent months.
BNP Paribas is the largest trader of property derivatives in France, with the bank claiming a market share of approximately 50% having traded volumes of €600m–€700m. Yet the bank is not a keen trader of derivatives referencing the DIX.
"In the German market, valuations on which the index is based come from a formula based on rental yield, not market valuations or sale values," said David Slater, head of property derivatives trading at BNP Paribas in London. "This makes derivatives based on German IPD dangerous as you are settling against a largely random number, so it is a little surprising to see the large number of reported trades taking place. Data shows the German property market has fallen since 1992 and yet investors say that is not the case. More recently it suggests values falling 2%–3%, while investors record 10% gains. The risk assumed in writing at the money options against this set of data is equivalent to playing Russian roulette."
The IPD-produced VIX index shows that while the total return was 1.3%, capital values on German property fell for the fifth consecutive year. The issue for some brokers is that they believe the calculation of the data should change and therefore there will be a dramatic overnight correction in the index when that takes place. Yet the documentation from IPD shows that, while there are minor differences between each market, the methods are equivalent to those in the UK and France.
A report by the Royal Institution of Chartered Surveyors (RICS) showed that since 1999 valuations in Germany have become increasingly accurate, with the disparity between valuations and achieved values at just 4.2% on a weighted basis in 2005. It also stated that the German valuation method used by open-ended funds and insurers corresponds to the UK market value. Both assume a non-stressed sale of assets in the near future. Even so if brokers aren't confident of the data then they won't seek to trade against it and this lack of market making is a further issue.
When the market first started brokers were keen to support its development by market making. This saw a number of houses writing options in May and June with an expectation that liquidity would rise reducing the cost of hedging their exposure. In fact liquidity fell. When the market turned almost overnight (many analysts began June saying 2007 would see a positive result and ended it suggesting losses) several houses found themselves in uncomfortable positions.
Now there is a greater focus on matching both sides of a transaction and avoidance of warehousing.
"There is now less appetite to hold positions and a focus on intelligently managing risk. We will show a price but won't over provide liquidity," said BNP's Slater. "You develop knowledge of where you can offset risk and different ways to do so. Property can be used to offset inflation, interest rate and equity exposure in the prop book."
Where the bank is looking for a third party to take the other side of a transaction it can take time to construct the deal with the result that the trade can take two weeks to complete.
The constituents in the market are increasing, however, with a handful of new counterparties appearing late last year, but there is little expansion on the investor side. There is an assumed restriction on the use of index-based property derivatives by open-ended funds.
BaFin stated that funds are able to use property derivatives for hedging, but they must be derived from money market instruments, units in investment funds, specific securities or REITs, and no extensions are planned. IPD believes this excludes index-based trades and as a result bans €80bn of assets under management from the market. This is double the current size of the potential domestic market of listed companies, insurers and pension funds. Whether these funds would actually be active participants is debatable, like much of this market. Schulte suggested that all the components are there for a derivatives market but the conservative nature of Germany just means the market will take years to develop and will never reach the size of the UK.