How Derivatives Give Shelter
Financial-Market Uncertainty May Be Catalyst for Big Boost In Instruments in U.S., U.K.
By MOLLY DOVER
September 26, 2007; Page B7
LONDON -- Uncertainty over global financial markets and a predicted downturn in commercial property could be the catalyst for a significant increase in property-derivatives trading in the U.S. and the United Kingdom.
In the U.K., derivatives trading has been growing, with £3.9 billion, or about $7.9 billion, in trades in the first six months of this year matching the total for all of 2006. In contrast, the U.S. market has struggled to take off. While there are no formal data, experts suggest that trades total in the hundreds of millions of dollars rather than billions.
As investor focus in the U.S. shifts from the subprime crisis to its effects on commercial property, investors are expected to start taking notice of derivatives. U.S. commercial-property values are expected to fall as investors fail to secure the debt necessary to close their deals. But falling valuations shouldn't have an effect on derivative trades, which are a bet on the likely future movement of investment returns.
"There has been a tremendous increase in inquiries from property companies to use derivatives as a risk-management tool, not just as a speculative tool, to diversify and manage risk within portfolios," said Philip Barker, senior vice president for property derivatives at inter-dealer brokerage GFI Group Inc. in New York.
Property-derivative contracts are a means of betting on property performance without the risks of buying property directly. It is more cost-effective than direct property investment, particularly in the U.K., where property purchases incur a 4% stamp duty tax. Derivatives can be used by those looking to diversify their general portfolio as well as by property companies to hedge their exposure to certain sectors of the market.
Successful investment in derivatives depends on accurate forecasting of the commercial-property market, which can be difficult. Moreover, investors don't have the same level of control over their assets as they would with a portfolio of physical assets, but it is quicker, cheaper and more liquid.
In the U.K., property forecasting is widely available to the public through industry bodies such as the Investment Property Forum, which provides data and forecasts. In contrast, in the U.S. this function is served predominantly by specialist research-and-data firms or the research department of property-services firms, such as CB Richard Ellis or Newmark Knight Frank.
The U.S. market also has a variety of indexes on which to trade, which can confuse investors, whereas U.K. trades are based on a single comprehensive index. Last week, Moody's Investors Service teamed up with New York-based Real Capital Analytics and announced plans to publish a series of commercial-property price indexes, which the firms say will boost U.S. derivatives trading.
While some U.S. investors may be wary of trusting property forecasts, the real stumbling block for many is their lack of knowledge or understanding of how derivatives work, said Reginald Ross, a director with the U.S. tenant-advisory firm Staubach Co. "Clients are looking for more complex and concrete answers for hedging down their real-estate risk. There is a pent-up demand for complex real-estate solutions."
Mr. Ross said the market indexes need to develop more quickly and banks need to educate the public and their clients. He said he is confident the Moody's and Real Capital Analytics index will take off, because it is based on actual sales rather than appraisals, something with which investors are more comfortable.
Second-quarter returns on property investments were 2.14% in the U.K., compared with 4.6% in the U.S., according to data from the National Council of Real Estate Investment Fiduciaries. That helps explain why U.K. investors are already looking to derivatives, while in the U.S. investors can still achieve strong returns from direct property ownership. But real-estate experts expect this to change as turbulence in the wider financial markets affects the commercial-property industry.
Derivatives performed strongly in the U.K. in August. Specialist derivatives-fund manager Reech AiM said its first European real-estate relative-value fund saw a 5% return for August, ahead of the flat property returns for that month and ahead of an average 1.3% fall in hedge funds, according to Hedge Fund Research.
The Reech fund, called the Iceberg Alternative Real Estate Fund, invests in property derivatives and listed real-estate securities and is a joint venture with CB Richard Ellis Group Inc.
"We do not believe that the turmoil of the current liquidity crisis is over, but the prevailing conditions are providing potentially very interesting opportunities for Iceberg," portfolio manager Stephen Ashworth said.
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