ABN AMRO and Merrill Lynch have given UK market its first subsector swap
Property derivatives in the UK took a big step forward last month, with the first subsector-specific swap, as ABN AMRO and Merrill Lynch took a €10m position in UK shopping centres. The banks also conducted the first sector-specific trade (UK retail) in November 2005, and ABN AMRO performed the first UK office sector swap in January.
Dominic Smith, research manager at IPD — against whose indices the real estate derivatives are traded – says the deals are “symbolic of the market becoming more sophisticated”. “It started off with trading against the all-property index, and they are now going into the subsectors,” he says.
Also last month, Barclays Capital and Protego Real Estate Investors back-to-backed a £90m total return swap and launched £90m of four-and-a-half-year property index certificates. They are issued at £111.25 for £100 nominal, and are targeted at private and institutional investors looking for UK property exposure.
For Smith, the deals are proof that the use of derivatives as a quick, effective and efficient risk management tool for real estate investment is maturing as investors are becoming more familiar and comfortable with it. “Fund managers who think that they are underweight, for example, in City of London offices in a given quarter can go to the screen and buy positions in City offices,” he says.
Protego principal Charles Weeks says: “The overall market for IPD-linked derivative products is expanding. In larger-sized deals PICS have proven to be a popular format with investors.”
A quantum leap forward for the pan-European sector would be the first trade in Europe outside the UK, or trades involving derivatives against more than one index. Paul Ogden, head of property derivative development at CB Richard Ellis-GFI, says the company is involved in deals being planned and executed in Europe, with France top of the list. “The driving force behind any derivative market is the quality of the index, so the main candidates would be France, Germany, Netherlands, Scandinavia, Ireland and Spain,” he says.
“The next important thing is the nature of the marketplace. Ireland, for example, is a very small market but it is totally do-able. But returns there wouldn’t set the world alight, so we would probably see the next big step in France and Germany.”
Other likely candidate countries include Denmark, Finland, Norway, Portugal and Sweden, using IPD annual indices, while Ireland could trade against the IPD quarterly index. Overseas markets are also coming into the picture, such as Canada, Australia or South Africa, as some of the banks are examining derivative products measured against the annual IPD indices of those countries.
For now, market rumour suggests that trading in the French index is imminent, although banks are remaining tight-lipped.
However, Phil Ljubic, property derivative trader at ABN AMRO, reveals that the bank is looking closely at trading against the Dutch and Danish indices, and has inspected France and Australia.
“We have a bid offer price out on some Dutch real estate, so we are willing to warehouse a small position to get the market against the Dutch all-property index going.”
IPD director Ian Cullen says the interest in the sector is huge: “I cannot remember an innovation, including real estate investment trusts, that has attracted as much interest, debate and discussion.” IPD’s new quarterly UK index – unveiled last May – is expected to become the standard for derivatives.
Later this month, IPD is releasing its first figures on trading volumes in the sector. According to Ogden: “Volumes traded in the UK in the second quarter of this year will be double that of the same period last year. This year the total for Q1 was greater than for the second half of 2005.”
One of the brokers dealing in the sector told EuroProperty he estimated that property derivatives traded in the first half of this year could amount to £1.5bn. “We think a large number of end-users – ranging from the big French and Spanish banks to large Dutch pension funds – are planning to enter the market during the third quarter of this year,” says the broker.
To stimulate interest in the market further, players in the sector are holding a series of educational forums to familiarise property companies, asset allocators, pension and life funds with the new derivative tool. At the moment, the investor pool lacks depth and anecdotal evidence suggests that the majority of derivative transactions have been inter-bank. Eleven banks now have licences to use IPD indices in the UK for derivative trading.
But many property funds, companies and institutions are in the process of getting their mandates changed, which will allow them to participate. Hermes, for example, has just secured approval and should be trading by the end of the year. Other new entrants include a joint venture between Cushman & Wakefield and broker BGC Partners, while DTZ and Tullett Prebon have also formed a venture.
German players are also starting to take notice. According to Dr Thomas Beyerle, head of research and strategy at fund manager DEGI: “Given that real estate is the biggest asset category in the German economy – with an estimated value of €7.2 trillion – and that, in the past, it has been virtually impossible to hedge these assets against unexpected developments, it is likely the demand for real estate index derivatives will grow along with rising demand for direct and indirect property investments.”
Interestingly, the European property derivative sector is ahead of the US. There have some deals, but the market is limited because the National Council of Real Estate Investment Fiduciaries has a trading agreement with just one bank.
| Market expected to hit £2bn this year |
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Britain’s property derivatives market offers over-the-counter trading in swaps based on the total return on the Investment Property Databank’s UK all-property indices in exchange for the interbank rate LIBOR plus a spread. Nearly £850m of trades were conducted last year, according to IPD, and some players expect the market to surpass £2bn this year. But with many investors, notably funds, still awaiting internal clearance to trade or holding out for more liquidity, the market has yet to take off fully. Derivatives will be ideal for relatively simple cross-border diversification, too. They allow investors to gain exposure without buying directly into a country’s real estate market. The legal advantage is clear: every European country has different legislation and tax jurisdictions on property deals, while derivative deals employ simple International Swaps and Derivatives Association-style documentation. “This document is becoming standard in the UK and will become standard across the international swaps markets,” according to Paul Ogden, head of property derivative development at CB Richard Ellis-GFI. The attraction of a pan-European market for derivatives would be the capacity for investors to compare property returns for, say, those of France with Germany and then make a quick exposure adjustment: should they opt for higher German returns it would be simpler to buy into real estate in Germany via the country’s derivative notes, thus gaining immediate exposure without the lengthy and expensive process of buying direct property. |
