Property derivatives

General Definition

A property derivative is a financial derivative whose value is derived from the value of an underlying real estate asset. In practice, because real estate assets fall victim to market inefficiencies and are hard to accurately price, property derivative contracts are typically written based on a real estate property index. In turn, the real estate property index attempts to aggregate real estate market information to provide a more accurate representation of underlying real estate asset performance.

Property derivatives usually take the form of a total return swap or forward contract, or can adopt a funded format where the property derivative is embedded into a bond or note structure. Under the total return swap or forward contract the parties will usually take contrary positions on the price movements of a property index.

The most common benchmarks used for writing property derivative contracts in the UK are the various property indices published by the [http://www.ipd.com Investment Property Databank] and [http://www.ftse.com/ukcommercialproperty FTSE UK Commercial Property Index Series] . The IPD Annual Index covers approximately 12,000 directly held UK property investments, market revalued in December 2006 at just over £192 billion equivalent to 49% of the UK investment market. IPD indices are also used in a number of other countries such as Australia, France, Germany, Italy, Japan and Switzerland as the basis for commercial property derivatives. A variety of indices are used in other markets such as the United States

The FTSE UK Commercial Property Index Series currently covers £16bn of prime investible property assets directly held in the UK. The FTSE UK Commercial Property Index Series is valued daily, on a T+2 basis.

Uses of Property Derivatives

Property Derivatives provide the investor with the ability to;

• Gain or reduce exposure to the property market.

• Hedge a current position in the physical assets.

• Quickly change the composition of a portfolio, i.e. switch out of Retail property and into Industrial.

• To speculate on the property market

All of these objectives can be achieved without having to transact in physical property.

Defining Property Market Performance

To create a derivative there needs to be a point of reference for the performance of the market against which the derivative contracts are priced.

In the case of property derivatives, this reference is provided by the Investment Property Databank and the FTSE index in the United Kingdom, and NCREIF, S&P Case Shiller and Rexx in the United States.

The IPD Index and the FTSE UK Commercial Property Index Series provide a number of indices which relate to performance of commercial property. There are many indices reflecting sectors and sub-sectors of the commercial property market. To date, much of the interest in property derivatives relates to the UK market and its sub-sectors. The main indices are:

• The IPD UK Annual Index and the FTSE UK Commercial Property Index Series.

1 - The IPD UK Annual Index covers approximately £192bn of directly held UK property investments. The Annual Index is published at the end of February every year. Its value relates to December the previous year.

2 - The FTSE UK Commercial Property Index Series currently covers approximately £16bn of directly held UK prime investible property investments. All Indices for this Series are calculated daily on a T+2 basis.

Both Indices are calculated using information from the 3 main sectors of

1. Retail Property

2. Office Property

3. Industrial Property

The IPD Index has the following components that make up the value of each of these and all other IPD indices are;

1. Income Return on commercial property

2. Capital Growth on commercial property

Income Return + Capital Growth ≈ Total Return¹

¹ The Total Return, as calculated by the IPD, is actually higher than the simple sum Income + Growth. See IPD website for explanation of the calculation.

The FTSE UK Commercial Property Index Series have the following components that make up the value of each of these and all other FTSE UK Commercial Property Index Series:

1. Capital Growth (NAV)

2. Total Return (GAV)

3. Total Return (NAV)

For most IPD property derivatives, it is the level of an Index, as published by the IPD, in a given year compared to its level in the previous year that determines the percentage return an investor will receive.

For all FTSE UK Commercial Property derivatives, it is the level of an Index taken on any day of the year compared to any other day.

Types of Property Derivative

There are 3 main types of Property Derivative in use in the UK property market today:

1. Property Index Notes(PINs)

2. Total Return Swap (TRS)

3. Forward

Property Index Notes

The PINs are essentially bonds. The cash flows of these bonds are structured in a way that is meant to be similar to a transaction in the physical property. This means that the PIN pays the capital return on redemption of the bond and it pays a quarterly coupon to investors.

In this way, the seller of the PIN pays the IPD annual or FTSE UK Commercial Property capital growth at redemption and the income return, paid quarterly (IPD) or monthly (FTSE), to the counter party. This means that the counter party is, therefore, receiving the total return of the UK commercial property market, just as they would with a physical transaction in property.

Total Return Swaps

A property total return swap is quite simply an exchange of cash flows. Here, the total return on property, as measured by the change in the relevant IPD or FTSE UK Commercial Property Index, is exchanged for the return on cash.

The UK IPD pricing mechanism was simplified on 15th January 2007. Rather than quoting libor +/- a spread, now it’s a fixed %. So take the Dec 08 contract for example if it has a mid of -11.5%. This means that if you ‘buy’ the swap, you pay -11.5% (so receive 11.5% due to the -ve sign) to your counterparty and receive the performance of IPD. (Or pay it out if it’s a negative number) No quarterly cashflows, simply one annual interest payment versus one annual property payment.

ISDA 2007 Property Index Derivatives Definitions

On Friday 4 May 2007 ISDA released the 2007 Property Index Derivatives Definitions. The definitions set out various market standard definitions which can be used in property derivatives transactions together with a standard form total return swap template and forward transaction templatecite http://www.mayerbrown.com/london/article.asp?id=3511&nid=1575 ISDA’s 2007 Property Index Derivatives Definitions: A KillerApplication for the Property Index Derivatives Market? by Edmund Parker] It is hoped that standardised documentation will kick start the market.

Articles

* [http://www.ftse.com/Indices/FTSE_UK_Commercial_Property_Index_Series/Downloads/FTSE_Indices_for_Property_Derivatives_0308.pdf FTSE Indices for Property Derivatives; FTSE]
* [http://www.dtz.com/static_files/Global/Static%20Files/PDerivNov07.pdf Property Derivatives;DTZ Tullet Prebon]
* [http://www.jcra.co.uk/pdf/JCRA_PropertyDerivatives.pdf Property Derivatives, A Meaningful Introduction to Property Derivatives]
* [http://www.mayerbrown.com/london/article.asp?id=3511&nid=1575 ISDA’s 2007 Property Index Derivatives Definitions: A Killer Application for the Property Index Derivatives Market? Edmund Parker]
* [http://www.tipsheets.co.uk/Propertylinkedwarrants.pdf Property Linked Warrants and Certificates]

Professional Associations

* [http://www.ipdindex.co.uk/ Investment Property Databank]
* [http://www.isda.org ISDA]
* [http://www.ftse.com/Indices/FTSE_UK_Commercial_Property_Index_Series/index.jsp FTSE Group]
* [http://www.aref.org.uk AREF - The Association of Real Estate Funds]

Footnotes