Awaiting a second wind

IFR Derivatives 2009
5 min read

The collapse of the property market should have provided the perfect conditions to drive growth in the property derivatives market as physical sales became all but impossible. Instead, the embryonic market slowed to a near standstill. With some tentative signs of a recovery, property derivatives could be about to get their second wind. Helen Bartholomew reports.

As a long-only business model, property investment has long appeared to be a natural candidate for a liquid derivatives market. That was certainly the view around five years ago, when the first tradable property derivatives were established to provide insurance against losses. Volumes were growing steadily until global property prices plummetted from their highs of mid-2007. Property derivatives volumes were decimated through the second half of 2008. Figures from International Property Databank show an 80% decline in 2009 trading volumes: Q1 trading figures totalled £606m, compared with £3.7bn a year earlier and £3.3bn in the first quarter of 2007.

While the UK remains the most significant market, the rest of Europe is struggling to make any headway. In the first quarter of this year, of a total 156 trades, only seven were French, worth a total of £143m. Germany accounted for a single transaction, according to IPD.

“Most markets develop slowly and steadily, but it’s absolutely unprecedented to see such a dramatic turnaround in a market’s development. At the moment we seem to be in limbo between the first and second stage of development in this market, and we hope to have come out the other side by the end of this year,” said the head of inflation trading at one bank in London.

But how accurate are the IPD figures? Stephen Ashworth, portfolio manager at alternative investment manger ReechAim, argued they are a huge under-representation of real activity seen in this market, accounting only for large block trades between banks and their clients. “We trade the IPD swap market actively, and trading volumes have remained at the same sort of level – if anything, they’ve picked up over the last six months,” he said.

If investors are awaiting some concrete evidence of stability and recovery, August’s figures from the IPD could provide the necessary impetus. The index shows a 0.2% increase in UK commercial property values, representing the first month of capital growth for more than two years. “Commercial property has delivered record losses, but has at least traced a relatively stable path towards this first tiny sign of recovery – in stark contrast with the much more violent oscillations of the equity and bond markets,” said Ian Cullen co-founding director of IPD.

Similarly, the CB Richard Ellis monthly commercial property index recorded a 0.5% increase in capital values for August, alongside returns of 1.2%. “Commercial property is not completely out of the danger zone, with downward pressure on rental values reflecting occupier uncertainty still present in the market. However, there are enough positive signs to be confident the market has turned a corner as far as investment pricing is concerned,” said CBRE analyst Nick Parker.

Bankers believe derivatives are increasingly becoming a requirement for effective real estate portfolio management. “Property is a long-only investment – so when the market goes down, investors will always take a hit. Ultimately the business is about selecting higher value assets than the rest of the market, rather than just taking directional exposure, and that screams out for hedging opportunities. If property companies don’t use derivatives to hedge their beta, they can easily enjoy five or six good years, but then they can still lose significant amounts when the market turns,” said Kara Lemont, European head of FX and rates structuring at BNP Paribas.

Despite the disappointing headline trading figures, there are some signs of a shift in derivatives usage. Second quarter figures from the IPD show a marginal increase on Q1 at £708m. Although still a long way behind previous years, it represents the first time in several years that second quarter activity exceeded that seen in the first quarter, and perhaps more importantly, bucks the trend of declining volumes seen in the institutional physical market over the same period.

However small the signs of recovery, market participants hope it will lead to renewed interest in property derivatives. “This is still a developing market and there is clearly an opportunity for more participants,” said Ashworth. “There are two main hurdles to overcome: understanding the market and operational issues concerning how to trade it. Real estate professionals have been somewhat preoccupied with other issues for the last couple of years, but now that we appear to have reached at least a temporary bottom, we hope to see more interest,” he added.

“There is a lot of liquidity in the system and very few real estate assets for sale. Clearly the market has fallen a long way, but it is plausible that we will see gains at the index level for some time to come.”