The once fast-growing property derivatives market picked up again in the last quarter, Julian Lewis reports.

Second quarter data from index provider IPD has given the stalled property derivatives area its first boost after 18 months of rapid growth came to a sudden halt during the credit crisis in the second half of last year. While the past quarter’s £708 million ($1.180 billion) of reported transactions still marks the second-lowest 3-month figure in three years, after Q1, it ends a run of four consecutive quarterly declines (from Q1 08’s all-time high of £3.7 billion down to £601 million).

Market practitioners welcome the turnaround. For many, the most notable feature of the recent three months was the uncommon quarter-on-quarter rise. Historically, as in many other markets, Q1 has been the year’s strongest for property derivatives by some way. It accounted for 40 per cent of 2007’s total volume and as much as 47 per cent last year, IPD data shows.  

Positive signal

“There may well be a very positive signal there,” comments Nick Scarles, chairman of the IPF Property Derivatives Interest Group (PDIG) and group finance director at Grosvenor.  “It really sticks out and suggests that the market’s attractiveness has improved. Hopefully, we can read a better sentiment about using property derivatives in the Q2 figures.”

Mr Scarles was “mildly surprised” by the new data. “Based on the historical pattern, we might have expected volumes to halve in Q2,” he said.

The second quarter’s pick-up contrasts with a continuing decline in the physical market. As a result, the derivatives sector gained slightly as a proportion of overall property transactions in Q2. Although its current ratio (a little above 20 per cent) is still a significant distance from the 30 per cent peak it had achieved a year ago, the quarter’s trading was broadly equivalent to all physical transactions in UK city centre offices so far this year, notes Paul Robinson, executive director, Real Estate Finance at CB Richard Ellis.

UK dominant, France finding feet

The UK remains the largest and most developed property derivatives market. IPD’s broadest UK index – the all property Annual Index, which measures all commercial properties (including the industrial, office and retail sectors) - is the key benchmark for swaps, though market participants expect sector-level trading to now take off as the resurgence continues.

Total UK volume rose to £601 million in Q2, an 8 per cent rise on the previous quarter. Compared to the same period a year earlier, however, it was down as much as 63 per cent - reflecting the overall contraction in derivatives since the credit crisis after Lehman Brothers’ bankruptcy last September.

Elsewhere, although no German trades were reported, trading in French property derivatives picked up significantly in the quarter. Banks licensed to offer contracts on IPD underlyings completed as much as £107 million of transactions – more than twice the £51 million reported in Q1, though this was one of the sector’s weakest quarterly performances since IPD began tracking it in 2007. The deals mainly reference IPD’s Paris all offices index, the de facto French benchmark.

As a result, France contributed as much as 18 per cent of total Q2 volume. On a relative basis, this was its best performance to date.  

This marked “an encouraging resurgence in French office derivatives”, according to CBRE’s Mr Robinson. He also cites Eurex’s listed IPD futures contract, which began trading in February but only began to attract volume during Q2, as another positive in the quarter.

PDIG’s Mr Scarles shares enthusiasm for the French pick-up, but cautions that further positive quarters are needed to confirm the growth pattern. Moreover, the key development in the market’s internationalisation will be when institutional investors are able to use property derivatives to achieve their regional asset allocations swiftly, he anticipates. “That will be a very useful tool for them,” he said.

Growth elsewhere

Note that IPD data does not reflect trading in several important property derivatives sectors. Firstly, it fails to capture the increasingly active UK residential area, where transactions reference the Halifax House Price Index (HPI).

The sector saw “a material increase in trades” during Q2, according to Mr Robinson at CBRE. This occurred both in swaps/contracts for difference (CFDs) and in options.

It also has to ignore the less developed US commercial and residential sectors. These are mainly tracked by the National Council of Real Estate Investment Fiduciaries (NCREIF)’s Property Index and Radar Logic’s RPX, respectively, though IPD recently launched a rival set of US commercial property indices. Competition among indices has slowed the US market’s growth by fragmenting trading and creating uncertainty among investors, according to market participants.

In addition, the small Hong Kong market – based around a suite of benchmarks compiled by the territory’s university – does not show up in its data.

Tailoring taking off

While it is still quite early to judge the current quarter’s performance, Mr Scarles reports “a number of interesting trades”. In particular, he notes recent sales of tailor-made options-based structures.

“Simple swaps are the market’s bedrock, but an increasing proportion of non-standard trades is an important development,” he believes.  “Being able to use options is a very powerful tool for property companies.”

He cites the example of a company buying a put on one of its properties. If the option’s strike price is set at the same level as the loan-to-value of its borrowing, “then the bank has de-risked its loan to a large extent.“

This is because the property’s value cannot fall below the base level established by the LTV. If it does, the put will be exercised against the market counterparty.

Clear opportunity

Both for these types of hedging transaction - which lenders can also make use of - and as an efficient mechanism for gaining exposure to property, the longer-term outlook for the product remains extremely positive, property derivatives players argue. The opportunity is clear - despite the huge size of the underlying asset class, which is comparable to other key investment areas, it is still only a £10 billion market (down from £12.5 billion at its peak).

This contrasts glaringly with outstanding derivatives on commodities, credit, currencies, equities and interest rates. Their notional value exceeds the underlying asset classes - by a significant multiple in some cases.

“The property derivatives market is evolving slowly compared to others, but it is moving in the right direction,” judges Mr Scarles.

“It would have been astonishing if trading volumes had gone up after Lehman Brothers. But I have no doubt that the inexorable growth of property derivatives will be re-established – institutional investors are still increasing allocations to property and wealth managers too,” adds Iain Reid, chief executive of Protego Real Estate Investors.

WealthBriefing will publish a substantial independent report on property derivatives next month, in partnership with Strategic Communication.