Property derivatives allow investors to perform a fast, low-cost and more dynamic execution of investment strategies in real-estate that would not be possible otherwise. Property fund managers may use property derivatives to
USA Property Index Return
UK Property Index Return United States
Investor
United Kingdom
Investor
Figure 6.1. Country property index total return swap.
Notes: Example of a real-estate total return swap across two countries. The returns on each country property index are swapped directly.
reduce tracking error, lock-in future property returns, reduce risk at total port- folio level and switch between various real-estate sectors.
6.2.1 COUNTRY SWAP
The investors in the country swap deal illustrated in Figure 6.1 will enter this deal based on their expertise in the domestic market. The advantage of this property derivative trade is that the investors will preserve the alpha on their usual portfolio and they will obtain beta diversification in the other foreign market.
6.2.2 CHANGING EXPOSURE
Property derivatives can be used to implement arbitrage strategies related to geographical opportunities or a lack of synchronization between major and less major real-estate markets. Relative value strategies can also be searched with the help of real-estate derivatives, allowing investors to aim at divergence or convergence trades. The investors can also use property derivatives to lower financing costs. In spite of liquidity problems, derivatives contracts with a large exposure of notional can be executed very fast, in contrast with direct investment in spot property markets where completing trades can take several months.
The deal illustrated in Figure 6.2 is beneficial for all parties since both par- ties only get a synthetic portion of portfolios in other sectors, hence they do not invest in physical assets and are saving transaction costs and the deal is executed much faster. The broker is only exposed to counterparty credit risk for which they will charge each party a fee reflecting the default risk of each counterparty. The fee could be structured as a lump sum paid at the inception of the trade or as a pay as you go annuity premium.
IPD UK Retail IPD UK Retail
IPD UK Warehouse IPD UK Warehouse
Warehouse Property Portfolio Retail
Fund Broker Logistic
Fund
Retail Property Protfolio
Figure 6.2.A cross-sector real-estate total return swap.
Notes: The cross-sector TRS between between a fund managing a portfolio of warehouses in the UK and a property fund managing a large portfolio of retail properties. Both funds are interested in diversifying their property portfolios. The broker takes positions in two cross-sector swaps with offsetting cash-flows.
Pension funds are typically interested in changing the nature of their portfo- lio and also have a well-diversified portfolio. Given the large size of spot real- estate markets in well developed countries, no pension fund can claim they are fully diversified without being exposed to real-estate risk. Hedge funds may also be interested in property derivatives to achieve synthetic exposure to a very interesting asset class. At the other end of the spectrum, real-estate companies are interested in using property derivatives for hedging current portfolios of properties or future property developments.
Real-estate derivatives, futures in particular, can be used to get market beta when investment portfolios are rebalanced following recent information. They can be also used to ramp up portfolios when a new line of business involving real-estate is opened. Another interesting application is the protection or vir- tual sale of a building development, locking the value prior to construction.
Alpha Beta Fund Management, an open-end investment company based in Ireland, does not get direct exposure to physical property assets but instead seeks more efficient means of harvesting real-estate index returns. The firm targets pension funds and other investors that are considering access to British housing by dealing in an over-the-counter property derivatives market which tracks the Halifax House Price Index (HHPI).
Another very interesting use of property derivatives is to extract the market view expectations on the future level of property across the next five years.
This information should, in theory, be at least more reliable than the similar type of information extracted from the REIT market where expectations can be skewed due to portfolio composition effects. The information extracted from IPD futures for example can be used as part of an analysis of the stability of a financial system and hence provide a great tool for policy makers, regulators
and central bankers. Depending on the jurisdiction in question, another pos- sible advantage of employing real-estate derivatives is a more favourable tax treatment. There are no transaction costs other than the usual bid-ask spread.
Compared to investing directly on the spot market, using property derivatives can save approximately 6.75% of the purchase price in stamp duty, legal costs, agency fees and sale costs in the United Kingdom.
Furthermore, the main usage of derivatives is to create synthetic trading positions. Thus, through derivatives, investors may be able to get exposure well above their capacity, they can get negative net exposure to the market and benefit from a possible market downturn. In addition, investors using TRSs employ a form of leverage exposure to property. They initially require only a margin of 5–10% of the notional size of the swap. Other advantages include the possibility of achieving a high level of diversification, low transaction costs, low volume entry, and quick entry into markets that may be opaque in their spot markets.
The example illustrated in Figure 6.3 shows how a real-estate derivative (RED) can be used to manage exposure to real-estate from different perspec- tives. Suppose that an investor in UK commercial real-estate (office, ware- houses, retail) has a portfolio of properties but for various reasons (tax, risk management, future tactical decisions) she/he would like to reduce the expo- sure to real-estate but without effectively going into an actual sale that may take a long time to execute and also cost some fees. A market broker knows that at the same time another investor such as a pension fund would like to get exposure to real-estate but once again they would not go into a real buy of properties.
The deal put together by the broker, two total return swaps, illustrated in Figure 6.3 shows that the buyer will pay a fixed rate interest rate to the broker and receive in exchange the IPD Total Return (income and capital); likewise
Fixed Rate % Fixed Rate %
IPD UK Total Return IPD UK Total Return
Property Portfolio Buyer
RED Broker Seller
RED
Figure 6.3. Managing real-estate exposure using a real-estate derivative (RED) contingent on a real-estate index such as IPD UK All Property Total Return.
the seller will transfer the IPD Total Return to the broker and receive a fixed rate, obviously smaller, from the broker. The seller will keep its alpha, the buyer will get exposure to a different asset class at a low cost and the broker only faces counterparty risk on both sides of the deal.
Example 6.1. As an example, consider that a housing building company starts a new building complex in New York and therefore is exposed to housing price risk in that area. They decide to hedge with a 3-year RPX forward trading at 4%
annualized rate. For the sake of explanation assume that the forward is 88.69.
Then the seller of the contract will pay the difference between the observed RPX and 88.69, if positive, at maturity. Likewise, the seller of the contract will receive the difference between 88.69 and the observed RPX at maturity. Suppose now that RPX falls somehow such that at the end of the three years it ends up at 91.39. Then the seller of the contract will pay 2.70% times the notional. If the RPX ends up at the level of 86.07 then the seller of the contract will receive 2.62% times the notional at maturity.
There are also some disadvantages of using property derivatives. When trading is done over the counter, counterparty risk is still an issue, and this coupled with the intrinsic illiquidity of the market may result in significant risk management problems at particular points in time associated with market downturns. Marking-to-market is still very difficult since property derivatives are still in their infancy and there is no generally accepted framework to price these products. Last but not least, the derivatives contracts in real-estate mar- kets can only be as good as the indices they are written on. The IPD index is an appraisal index and therefore is based on the subjective beliefs of appraisers.
Other disadvantages include insufficient liquidity, lack of data available for model calibration, as very little is known on the risk management side.
6.2.3 REBALANCING A DIRECT PROPERTY PORTFOLIO
Here we illustrate how the IPD futures traded on EUREX can be used to reduce tracking error and rebalance the portfolio for the 2017 horizon. The example below uses fictitious numbers not real market numbers.
Suppose that a UK property fund is benchmarked to the total return per- formance of the MSCI IPD Quarterly UK All Property Index. Based on this benchmark index assume that in June 2016 the fund has an underweight position of £100 m to the UK Shopping Centre and an overweight position of £100 m to the UK Retail Warehousing. The manager of the fund aims to rebalance his overall position to reduce tracking error and boost his overall portfolio return for 2017, expecting Shopping Centre to do better than the retail warehouses by 6% (12%–6%). Rebalancing the property portfolio in the spot market will attract high transaction costs and may take a long period of
Table 6.1. Rebalancing strategy first trade June 2016: long 2017 IPD UK Quarterly Shopping Centre Index.
Year 2017 Manager forecast Shopping Centre Total Return 12.0%
Less Futures IPD UK Shopping Centre 8.75%
Less Liquidity Risk Premium 0.0%
Less Transaction Cost 0.25%
Expected Return 3.00%
Table 6.2. Rebalancing strategy first trade June 2016: long 2017 IPD UK Quarterly Retail Warehouse Index.
Year 2017 Less Manager forecast UK Retail Warehouse 6.0%
Futures IPD UK Retail Warehouse 8.0%
Less Liquidity Risk Premium 0.0%
Less Transaction Cost 0.25%
Expected Return 1.75%
time. Alternatively, the fund manager could enter long futures on IPD UK Quarterly Shopping Centre for a £100 m notional and maturity 2017 and simultaneously enter short futures on IPD UK Quarterly retail Warehouse for a £100 m notional and 2017 maturity.
The strategy is described in Tables 6.1 and 6.2. If the manager’s forecasts prove to be correct this strategy would then also produce 4.75% returns on
£100 m notional.