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A derivative is a financial instrument that is valued in relation to an underlying asset or price index. Derivative instruments can be used to hedge risk in portfolios and business operations. When used as a trading instrument, they provide exposure to the price movements of an underlying market. Property derivatives can be traded quickly and easily, in contrast to physical property transactions with the involved processes and associated costs. A recent survey by the Property Derivatives Interest Group (PDIG) suggests that there is considerable demand for such products in the financial community, and groups controlling nearly $81 billion of commercial property have already been cleared to trade in this new market. [1] Some observers have pointed out that property is one of the last major asset classes in the Western markets without a liquid derivatives market behind it. The UK may have the advantage in leading the market forward due to the availability of relevant property indices, such as the Investment Property Databank (IPD) UK property index (IPD is a private firm that collects information on property market performance across a variety of countries and is considered to be the leading benchmark. http://www.ipdindex.co.uk/results/indices/indices.asp). The market is still in its infancy, and matching buyers and sellers can be difficult. Perhaps ₤600 million of derivative transactions have been done in the past year, compared with ₤50 billion of direct deals in commercial property that are now done each year. [2] To date, many derivatives – type deals have been done through Property Income Certificates (PICs). PICs were introduced in the 1990s, but are seen as bond instruments that pay a return based on based on an IPD index, rather than pure derivatives. The first pure derivatives swap, arranged between Deutsche Bank and Eurohypo, “brought together a buyer and seller of UK property risk. The seller exchanged a total property return (comprising income and capital returns) for a Libor-related return paid by the buyer based on a notional principle”. [3] In other words, the seller of property risk reduced their exposure to the property markets while holding onto the underlying investment properties in their portfolio. The buyer gets exposure to UK property market returns without having to purchase the physical properties and incurring the associated costs. Contracts are “presently executed as matched bargain trades between buyer and seller”, with pricing determined through negotiations between buyer and seller. As the market becomes more liquid, standardized contracts could become available directly through intermediaries, “who will price the contracts and assume the risk of finding a suitable counter-party”. [4] Observers feel that growth in the property derivatives market must be led by an increased understanding of the instruments and their potential benefits. Management of property risk can be dealt with quickly and relatively cheaply, saving on transaction time and costs. [5] To quote one property researcher, “If you want to reduce property exposure, derivatives allow you to do that without selling a portfolio you may not be able to get back.” [6] If the property derivatives market can gain sufficient liquidity, it is felt that property investors, occupiers, hedge funds and retail investors will come to use them. The market is currently focused on establishing all-property swaps and future property swaps could be developed for sub- sectors of the property markets. [7] There is already mention of creating capital or income-only swaps, reminiscent of the splicing and engineering used to create the separate IO and PO tranches of a CMO bond. There is hope is that property derivatives will develop into an international market, and further speculation suggests we may one day see the development of a property futures market. [8] Forecasts on the growth of the property derivatives market have been optimistic, with some suggesting a market size in the UK approaching ₤3 trillion over the next few years. [9] Others have extrapolated future growth possibilities by charting the growth of other derivatives markets. “The derivatives market in other asset classes has matured to at least the same size as the underlying market within 3 to 5 years. Commercial property has the same potential,” claims Martin Samworth, a managing director at CB Richard Ellis. [10] In spite of all the hoopla, some interesting questions and criticisms remain. One article made the point that it might be hard to find parties to take the other side of a trade “given the herd-like behavior of many property investors”. This is an interesting concern. However, in the future, added liquidity could attract disinterested players outside of the real estate circle whose main focus will be to speculate as contrarians. The same article went on to quote an Investment Property Forum (IPF) research director who spoke of a “huge divergence in views” regarding the future of investment property. He cited a recent IPF survey that showed, “Forecasts over five years for overall UK property returns ranged from an annual 6.5 per cent to 11.2 per cent”. [11] At the risk of misinterpreting these sentiments, it seems that the divergence of opinion is centered on the degree to which returns will be positive over the period. Property derivatives have been launched before, only to fail. Their previous debut on the London FOX in the early 1990s crashed in a combination of bad timing and scandal over false trades designed to create the impression of higher activity. The proponents of a property derivatives market might take heart that this resurgence is happening amid an uncommon level of enthusiasm for real estate investment products. Said one such proponent, “What I think is quite interesting is if you turn the clock back to 1981, and you ask people if they used interest rate derivatives, they’d say no, and that was the year the first interest rate swap was done. Now it’s a trillion dollar market. I expect a similar sort of growth in terms of the property market.” [12] [1, 2, 11] Pickard, Jim. “Green light for property derivatives”. Financial Times 29 August, 2005, USA Edition. 17. [3-5, 7-9] Rothery, Andrew. “Why the success of property derivatives is far from certain” Finance Week 2 March, 2005: 17. [6] “Standard Life, Property Firms Use Swaps to Hedge Risk (Update 1)”. Bloomberg.com 11 Aug, 2005. 27 Sep, 2005. http://www.bloomberg.com/apps/news?pid=10000102&sid=a_4M1EwadcCw&refer=uk [10] “Firms eye property derivatives trading”. IPE.Com 6 Jul. 2005. 27 Sep, 2005. http://www.ipe.com/article_default.asp?article=19055 [12] Phillips, Maha Khan. “Property derivatives on the rise” Global Investor vno172 p63-4, May 2004.
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