Real Estate Finance: The cusp of change
The last quarter may have been the UK commercial property derivatives market’s most active, as on some estimates £2bn–£2.5bn was traded. That compares with a cumulative notional of £4.6bn traded in 2006. But it will be the installation of global, over-the-counter (OTC) commercial property derivatives markets that tests whether the commercial property derivatives markets will flourish in the long-term. Jean Haggerty reports.
The most optimistic projections estimate that the global commercial property derivatives markets will total US$150bn by 2011. A big portion of this growth estimate is predicated on the fact that the US commercial property market is 26 times the size of the UK physical market, so when the US property derivatives market’s development catches up with that in the UK, the global property derivatives market should get a huge boost.
Little actual trading has occurred in the US commercial property derivatives market so far. The fact that many of the 11 banks that have been making markets in the UK's more developed property derivatives market are US institutions should accelerate development of the US market, but for now that market is only starting to find its feet.
In March, for example, Bank of America, Credit Suisse, Goldman Sachs and Merrill Lynch signed three-year licensing deals for trading US commercial property derivatives based on the National Council of Real Estate Investment Fiduciaries' (NCREIF's) benchmark commercial property index. For BofA, Goldman and Merrill, the move was a debut index licensing arrangement in the US commercial property market.
Initially, market participants had been reluctant to participate in the NCREIF index because it only had one dealer – Credit Suisse – making markets in it. This situation ensured that only a handful of property derivatives transactions were executed on NCREIF indices. But last year Credit Suisse approached the NCREIF about opening up its exclusive contract to trade derivatives based on the index to develop growth by enabling more market makers to come into the product.
Property derivatives markets in Asia and Continental Europe are also starting to develop. Asia saw its first property derivative transaction in early March when ABN AMRO Bank and Sun Hung Kai Financial struck a HK$100m (US$12.8m) one-year property swap based upon Hong Kong residential properties.
But for now, UK market participants are directing most of their attention to the Continental European commercial property derivatives market. So far, the trading activity in the Continental European commercial property derivatives markets has been light. That said, the publicity that property derivatives have received in the UK is spreading into Europe, said Juergen Feil, director of property derivatives at Deutsche Bank.
The first pure property derivatives transaction in the UK was executed in January 2005. The trade involved simultaneous transactions entered into by a UK insurance company and a major British property company via Deutsche Bank and Eurohypo.
Merrill Lynch and AXA REIM late last December executed the first commercial property derivatives swap in Continental Europe, and Goldman Sachs recently achieved two firsts in one trade when it transacted the first commercial property derivatives trade in the German market, and sold the first property derivatives index option on a mainland European IPD index.
Among UK market practitioners, enthusiasm for gaining access to the French and German commercial property markets through derivatives runs high. The French market is generally expected to develop more quickly because more regulatory hurdles exist in Germany, market participants say.
The way forward
As much as 80%–90% of the UK commercial property deals executed in the UK are total return swaps on total return swaps on the Investment Property Databank (IPD) All Property Index.
"We see some quotes and trades on options [on the UK IPD All Property] in the market . . . The next step is quanto structures. Having quantos enables us to quote UK IPD against other European indices in one total return swap. We see more and more demand for this within our client base," Deutsche Bank's Feil said.
The UK IPD indices are published more frequently than IPD indices covering France and Germany, which only come out once a year. This creates a challenge, though not an insurmountable one. French and German IPD indices may not come out monthly like the UK IPD indices, but investors can always opt for annual coupons, Feil noted.
The IPD is doing what it can to create a service in other European countries that is similar to what it offers in the UK The IPD has been taking steps to publish indices more frequently, but its influence is limited as the indices are driven by the underlying market.
During the past year, development of the market for UK commercial property sector indices has taken a back seat to developing the market for country-specific exposure. That is not to say that sector index activity has lost its momentum. UK IPD sector index trade has increased during the past year, but the market still trades by appointment. ABN AMRO executed the first sector-based trade in the UK property derivatives market in November 2005.
“It’s just easier to get a two-way market in reasonable size (£25m–£50m) on the IPD All Property than it is in the sector indices,” an interdealer broker noted.
“What investors want [from the property derivatives market] is the ability to recalibrate asset allocations and gain risk diversification without having to go into buildings and build up local knowledge. It’s easier to do [an All Index] cross-border swap,” another official added.
ISDA initiative to help
The imminent arrival of relevant definitions and documentation from the International Swaps and Derivatives Association (ISDA) is bound to give all property derivatives markets a boost. ISDA is issuing its first set of property derivatives definitions and standardised confirmation documentation covering total return swaps and forward contracts based on property indices.
"Grand predictions of explosive growth in the property derivatives market have been repeated for a several years now, but a shortage of liquidity, driven by a lack of standardised documentation and insufficient diversification of underlying indices, has prevented property derivatives from entering the mainstream,” said Edmund Parker, partner and a derivatives and structured finance specialist at Mayer Brown Rowe & Maw in London.
ISDA's Property Index Derivatives Definitions and template confirmations should go a long way towards resolving this, he added, noting that the 20-plus US City Standard & Poor's Case-Schiller Indices and the many subsets of the IPD indices show that the index providers are making strong progress too.
The 2007 ISDA Property Index Derivatives Definitions and confirmation forms will cover both the residential and the commerical OTC property derivatives markets. The confirmations can be adpated to any property derivatives tranactions that market participants want to enter into.
Until now, each derivatives house operating in the OTC derivatives markets has relied on its own documentation, and as OTC equity derivatives transactionas are often index-based, documentation often took the form of modified ISDA equity derivatives documentation.
Hedge fund participation grows
According to industry officials, the impact of greater hedge fund involvement in commercial property derivatives – either through dedicated property derivatives funds or through an increase in funds dabbling in the space – will start to be felt this year.
Greater hedge fund involvement will increase liquidity and greater liquidity is what is needed, said Paul McNamara, director and head of research at the global real estate investment management firm PRUPIM in London.
“They will help tighten up pricing across markets because they are looking for arbitrage opportunities,” he added.
The growth of the property derivatives market, together with the expansion in the listed market, including REITs, has resulted in sufficient liquidity to launch a dedicated relative value fund, according to Chris Iley, a portfolio manager at Orn Capital, which launched the market’s first dedicated property derivatives fund, the ORN Property Derivatives Fund, in January this year.
"Being first to market places us in a position to take maximum advantage of the investment opportunities inherent in this rapid growth," Iley said. The new fund pursues a relative value strategy with the flexibility to go long and short in the UK, European and US property derivatives markets.
Physical market drivers
According to market participants, the ongoing health of the physical UK commercial property market during the past few years has acted as a barrier to the derivatives market’s development.
“[For certain investors], until they feel that they can’t meet their budgets by doing past strategies – that those past strategies will not bring in the same revenues – they will be in no hurry to adopt new methods of portfolio management like derivatives,” said James Adam, head of property derivatives at ICAP in London. Total returns on the UK IPD All Property index for the past two years came in at levels in the high teens.
A lot of market participants were surprised on the upside by returns in 2006 and 2005, but with capitalisation rates now at all time lows it is not easy to see them push down further.
"Not surprisingly, debate continues in the market on whether the risk premium for property has declined recently," said PRUPIM's McNamara.
Investment Property Forum expectations are for a roughly 9% total return increase on UK commercial property values in 2007, and a 5% increase is forecasted for 2008.