Property companies remain wary of derivatives

US tax change should boost property derivatives

Like any new financial instrument, property derivatives have taken a while to catch on. After a tough second half of 2007, volumes have increased in 2008 on the back of increased usage by institutional investors and hedge funds. Nevertheless, most of the action in property derivatives has been dominated by the UK indices and on the whole the instruments have not been embraced by property owners.

In the second quarter this year, volumes of IPD Property Derivatives traded rose by 42% across the board on the same period in 2007, to £1.88 billion ($3.52 billion). In the three-month period ended June 30, 302 trades were completed, compared with 283 in the first quarter of 2008, the previous high mark.

The bulk of volume came from trading on the UK IPD indices, which accounted for £1.62 billion of the total worldwide volumes. Other markets, notably France and Germany, have been active, albeit on a much lesser scale. In the second quarter, first-time trades were completed in Canada and Spain. Now that a US tax code regarding the taxation of foreign investment has been clarified to exclude derivatives, that market is expected to grow (see US tax change should boost property derivatives, Liquid Real Estate, Issue 07).

Hedge funds, in part, explain the growth in volumes. Dealers and brokers report that hedge funds have been attracted to the instruments. Some are trading opportunistically, and dedicated property hedge funds have used them extensively. In addition, large institutional investors – pension fund managers in particular – have increased their usage of property derivatives to aid in the asset allocation process.

"We are primarily seeing flows in various UK indices from a mixture of institutional and opportunistic investors," says Simon Ziegler, director of global structured rates at Deutsche Bank in London. Deutsche ranked first in global property derivatives in the 2008 Liquid Real Estate poll. Ziegler notes that his team is seeing investors taking both sides of property derivatives trades—the market is not all one-way traffic. Some are bullish, others maintain a bearish stance.

"Pension funds and insurance companies are tending to use the product for asset allocation and getting index-tracking exposure to property," says Caspar Cook, senior director in research at Merrill Lynch in Edinburgh. "We also have the physical property holders, such as Reits and property funds, using the market as a portfolio management tool, while hedge funds are using it for relative-value plays." Real property holders, property funds and Reits have been much less active in the market than hedge funds and institutions. In fact, this end-user group is conspicuous mainly by their absence.

"[Direct property holders’] presence in the market has not grown as quickly as expected," says Cook. "It’s slightly disappointing that they have been slower to see the benefits."

At a time when property values have dropped precipitously, many believed property owners would be attracted to derivatives for their usefulness as a risk management tool. Now that liquidity has returned to the UK IPD indices, end-users’ ability to trade forward prices and therefore forward expectations on property as opposed to the price today has increased. The derivatives market has priced in a drop in capital values over the coming years, giving end-users the chance to take a view on this prediction.

"Clients are able to trade around whether they believe such forward capital values drops are overdone or underdone, rather than having to wait around for the cost of physical property to drop with time to an attractive level," says Deutsche’s Ziegler.

Direct property owners and funds have been hit where it hurts since the credit crunch clamped down on the markets in August 2007. It could be argued that had the prudent use of property derivatives been widespread, some property companies might have been able to mitigate some of the pain. But these instruments were not and are still not part of property companies’ risk management tool kit. A lot of the reason why they are not has to do with market timing.

"Property companies that looked at their overall exposure to real estate and felt that the market was about to turn, as a number did this time last year, could have reduced the size of their portfolio considerably for two to three years through the use of derivatives," says Nick Scarles, group finance director at Grosvenor Group in London. "The reason we haven’t seen trading strategies along those lines is more about market timing than a lack of desire to do it."

The property derivatives market turned in the summer of 2007 in the same way that a lot of other markets turned. If a property company wanted to reduce its exposure to real estate at that time, it would have been giving away about 10% on a one-year forward contract. So, at the time, the cost to reduce exposure through real estate was unattractive. Unless a property company was already in the market, by summer 2007 it was too late to put on a hedge.

Apart from bad timing, there are other reasons why property companies have not jumped into property derivatives. One reason, admit dealers and brokers, is the stigma surrounding derivatives, especially in the wake of numerous derivatives-related debacles and a lack of risk appetite thanks to the sub-prime crisis. As simple as it seems the negative perception of derivatives still held by some clients makes the instruments a tough sell, especially to those not well versed in their benefits, drawbacks and uses.

"Some property investors have relatively limited experience with financial instruments. Using property derivatives can be quite a big step for them," says Merrill’s Cook.

But there are other fundamental reasons why property derivatives aren’t the no-brainer they appear to be, especially for listed property companies. Mark-to-market accounting is a big barrier for some. Listed companies are required to mark to market any derivative positions at year-end and, depending on market conditions, the derivative position will be either in or out of the money.

In theory, a derivative should work in an equal and opposite way to the position it has been put in place to hedge. So when the position is in the money, the derivative is out of the money and vice-versa. The upshot is that, when marked to market, it is possible for a derivative hedge to create a big hole in a company’s balance sheet – a hole that it is difficult to explain away to shareholders.

"It is very easy for someone at a non-listed company to dismiss this issue. But for listed companies, it is a challenge," says Grosvenor’s Scarles. "The glib answer is that if you can explain all this to investors and you’re doing something that’s inherently good for the company they should be fine with it. But a caveat that says ‘excluding the impact of derivatives profits would have been X’ looks like you’re trying to make an excuse rather than explaining what your business really is."

Accounting issues and shareholder education are far from the only reasons why property companies have been slow to embrace property derivatives. In the UK, the main property derivatives market, most property companies are focused on the local market. They don’t have a need to diversify their portfolios into other countries using derivatives. As UK Reits become increasingly sector specialized, another argument for derivatives use disappears. Reits won’t want to use sector derivatives. It just doesn’t make sense from a strategic point of view.

Another reason property derivatives scare property companies is that their use might give investors the impression that the companies have strayed from their primary purpose, which is direct property investment. Investors buying shares in a property company often do so as an alternative to buying property directly, so if they discover it doesn’t have the net real estate exposure, it could lead to disappointment.

"There’s a concern clients prefer physical property holdings rather than taking exposure through derivatives," says Cook.

Not all property companies have eschewed derivatives, as there are obvious practical uses for these instruments. A handful of large transactions have been executed by UK property companies this year. Furthermore, some companies and fund managers have realized that derivatives use could have helped them better navigate the tough markets of the past year.

An example of a trade completed by UK property companies would be one taking a bet on the direction of the market. For example, if the index is pricing in a 15% capital fall and the property company’s view predicts a 12% fall, it can use property derivatives to monetize that view. This type of trade, so far, has been common among property companies.

"Over the course of 2008, we’ve seen property funds coming in and utilizing property derivatives to lock in outperformance," says Michel Heller, a broker at CBRE GFI in London. "We’ve also seen a general increase in understanding of what the property derivatives market is from property funds and companies." CBRE, which operates a property derivatives desk in partnership with broker GFI, has established a new desk to address funds’ and companies’ risk management needs, including the use of derivatives. Created in the second quarter of 2008, the new unit is already receiving a decent amount of queries.

"Property companies are starting to talk about property derivatives in the light of risk management," says Heller. "That property derivatives can be used to allocate assets quickly is something property companies have taken a shine to."

One use of derivatives taken seriously by property companies is their ability to hedge market risk in developments. If a company is undertaking a development that will take three years, for example, the site cost is known, as is the cost to build. What is not known, for certain, is where the property market is heading. That’s where derivatives come in. If a developer expected to deliver a project in three years, to hedge the risk that property values might move down it would sell the appropriate property index for three years.

Another serious application of property derivatives, especially for funds but also for property companies, is in the creation of a liquidity facility. What has happened in UK property funds is a good illustration. Earlier this year, some large funds were forced to cease investor redemptions because of lack of liquidity. If these funds had used property derivatives, some of this problem, and the attendant embarrassment, might have been avoided. A permanent liquidity facility using property derivatives would have enabled them to honour the redemptions, simply by unwinding the derivatives positions. They wouldn’t have to depend on selling property to raise the cash to return to investors.

"Funds have a permanent need to manage liquidity, whether it’s inflows or outflows," says Merrill’s Cook. "When the outflows stop and money comes back into the fund, they still have issues. If they have big inflows, it takes time to find properties to buy and put that cash to work."

Cook and others suggest using derivatives to gain exposure to the market while looking for properties to buy, then liquidating the position once the physical asset has been purchased. Derivatives’ capacity to provide liquidity is something many property fund managers wish they had taken advantage of.

"Some property managers believe if they had used this strategy they would have been much better off," says CBRE/GFI’s Heller. "Property funds would have been better placed to deal with a lack of liquidity in a turning market."

It has been something of a disappointment to dealers that property companies have not yet wholeheartedly embraced property derivatives; lessons learnt from the present downturn have gone a long way to highlighting the product’s merits. Property companies might not have been aware before of what they were missing by not using derivatives but now some players, particularly the larger, sophisticated ones, are acutely aware of opportunities they’ve missed.

Now that this awareness has been raised, it’s just a matter of time before property companies come into the derivatives market in earnest. It’s not going to happen overnight, stress market participants. Rather, like any new instrument, it will take time and further education. However, next time the property markets rapidly decline, property companies with outdated risk management practices will come under scrutiny for not using derivatives as part of their strategy.

"Any serious property investor today, even if they’re not using derivatives, will need to be explaining to their clients why they’re not," says Merrill’s Cook. "They need to be able to understand the product and, if it’s not suitable for them, to explain the reasons behind the decision."