As reported here previously, a £100 million package of sub-sector swaps emerged just before Christmas. Brokered by ICAP and with Royal Bank of Scotland as swap counterparty, the landmark series gave the Prudential long and short positions of multiple maturities in several UK commercial property sub-sectors.

Index provider IPD divides the commercial property market into three sectors: industrial, office and retail. It further divides these into 10 sub-sectors, such as West End offices and shopping centres.

Sub-sector signal

The Prudential package (traded by the insurer’s PRUPIM property investment arm, which has over £15 billion under management) ranks as the largest property sub-sector derivative transaction yet reported. But its significance goes beyond its eye-grabbing size, argues Paul Rostas, head of property derivatives at ICAP.

“Sub-sector swaps are not new. We have been working very hard for a long time on delivering liquidity to this area, but there has been a stand-off between market-makers and end-users about making prices. PRUPIM know better than anybody at what price the derivative works for them, which enables them to be a price-maker - not a price-taker – and starts a sensible discussion,” he says.

The anonymity gained by trading through ICAP, whose role as a broker and advisor included preparing the market and finding a counterparty for the swaps, reinforced PRUPIM’s enthusiasm for the deal. In turn, its signal effect for other property investors has been powerful.

“Liquidity begets liquidity. The PRUPIM deal has been very, very helpful,” judges Rostas.

The deal’s impact has already been visible in the first months of 2010. Although smaller, further sub-sector transactions have been completed this year as traders and investors have sought to exploit the opportunity for more targeted property exposures that the instruments afford.

“Some have gone through in Q1, though not anything like Q4,” Rostas confirms. “We see interest from the market across the range of sub-sectors. People are certainly willing to entertain the product. I think we will see more transactions coming through.”

New year sustaining

More generally, the first quarter appears to be sustaining the market’s recovery as direct property investment rises – though completed volume may fail to match the fourth quarter and could end up closer to Q3’s level, according to dealers.

Some of the shortfall is due to deals that are still likely to close, but now appear likelier to trade in April than March.

One clear positive, meanwhile, is investors’ increasing willingness to use derivatives when they are unable to buy physical properties. Historically, uninvested funds have been parked in cash or – more riskily – placed in shares of listed property companies.

Both strategies are inefficient since they fail to give pure real estate exposure (or indeed any, in the case of cash). Derivatives, in contrast, provide a property market-indexed return.

In addition, a significant proportion of property funds have needed to change their investment mandates in order to trade property derivatives. An increasing number have enlisted lawyers for the long-winded process lately.

Overall, momentum is rising. “A number of industry specialists have seen PRUPIM and other positive developments and realised what derivatives can do for them,” Rostas says. “There’s been a lot of interest and discussion. More and more people are getting educated and comfortable in the product and more and more are ready to pull the trigger.”