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Western EuropeOctober 2 2005

UK cultivates property derivatives market

Many believe that property-linked instruments are poised to become the next big thing in the derivatives market – but they are not sure when. In the first of two articles, The Banker looks at how the market is likely to evolve.Natasha de Teran reports.Concerns about overheating in the UK property market have been as widespread over the past few years as they ever have been, with many fearing the worst from the record rise in asset prices.
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In theory, this should be a good time for a property derivatives market to develop. It would enable property market investors and developers, home owners and others whose wealth or income is linked to or dependent on property market values, to hedge their assets and liabilities. But despite considerable excitement about the market’s potential, the going so far has been slow and practitioners have still to develop a game plan that will help foster its development.

Property derivatives have been around for some time, and sceptics might point out that so far they have shown no signs of taking root. As far back as 1994, the Financial Times ran an article headlined ‘Uphill struggle to drum up interest in property derivatives’. Even before that, in 1991, the London Futures and Options Exchange (Fox) admitted defeat with an ill-fated property futures contract. The contract had reportedly been manipulated to inflate trading volumes, and its demise was accompanied by the resignation of four Fox directors, and fines for five trading firms.

Optimal time

Kate Morrison, a director in debt capital markets at Deutsche Bank, is a firm believer in the market’s potential but concedes that the market has experienced “several abortive attempts” to get off the ground. She is nonetheless confident that the time and circumstances are optimal for it to do so now.

“Admittedly, there is still much educating to be done, and there is still some suspicion about the ‘derivative’ word, but the circa £700m worth of trades that have been closed in the past 12 months is encouraging,” Ms Morrison says.

She is not alone – other key supporters of the market include pivotal property industry figures such as Paul McNamara, research director at Prudential Property Investment Managers, and Phil Nicklin, real estate tax partner at Deloitte.

Such is the enthusiasm over the market’s future, that estimates of its potential size go as high as £20bn within just a few years’ time – yet there are still many doubts over the shape it will take before reaching such dimensions. One of the few certainties that can be deduced thus far is that the property derivatives market will take off in the UK first. This is unremarkable, given that the City of London is something of a hothouse for derivative innovations, but it will be an unusual coup for the UK in that the market will grow from a UK-centric base, with UK underlyings, UK investors and UK banks leading the way.

One of the principal reasons for this is the high degree of institutional ownership of commercial property assets and the long-standing tradition of private home ownership in the UK. However, other factors – such as the existence of a reliable and transparent series of indices, recent favourable changes to the fiscal treatment of property derivative transactions and a move by the UK’s Financial Services Authority (FSA) to make property derivatives admissible assets for life funds – have helped to cement the UK’s chances of spearheading the market.

Sizeable transactions

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Paul Coleman
Paul Coleman, director and head of property derivatives distribution at Barclays Capital, is confident the UK will not let the opportunity pass. “In the UK, we have what is probably the most robust index as well as some of the best fundamentals for the market’s development,” he says. “There is a well-established property market, and most institutional investors will be benchmarked to the Investment Property Databank (IPD) index, so they are already comfortable with it. Already this year, it has been very encouraging to have seen the involvement of a wide range of buy and sell side players in what have been some sizeable transactions.”

 

The £700m or so worth of commercial property transactions that Mr Coleman and Ms Morrison refer to include two each from Barclays Capital and Royal Bank of Scotland (RBS), at least one by Deutsche and Euro Hypo, and another transaction by TD Securities. Unfortunately, few of the participants on the deals are willing to go public – an issue that is likely to hinder the market’s development for some time. Mark Lambert, head of property derivatives at the RBS, reports that he has closed around £200m in property deals so far this year – but regretfully is unable to comment on any of them. He can only say that they have all followed the template laid out in the market: three-year total return swaps linked to the IPD All Property index. “The problem is there is some inertia, and an element among many potential users of not wanting to be first, and, while we are happy to publicise deals, our clients are often not,” he says. “That is a shame, as the more deals are publicised, the greater the awareness.”

Commercial focus

Most banks are focusing on derivatives linked to the commercial end of the property market. At first glance, one could think these might appeal to mortgage lenders and prove a useful adjunct in the lending banks’ armouries, but the bankers believe these are unlikely to be early entrants to the market.

“Mortgage lenders do not appear to be big players in the market – perhaps because there is no linear correlation between their profits and property market performance. I would imagine, however, that once the market becomes liquid, they will begin to use the products for general purposes, rather than as strategic hedging solutions,” says Mr Coleman.

Given that mortgage lenders tend to be equipped with a ready fluency in derivatives, their likely late entrance will disappoint those promoting the market. Property derivatives proponents are well aware that, while the products will have an immediate appeal to institutional investors and property companies, they will have to overcome the obstacles of lack of education and awareness. And because volumes are slim, the amount of time and effort that can be dedicated to the market is limited.

Few banks have even set up dedicated property derivatives businesses. Most only have a staff member or group of staff working on the products part-time. Mr Lambert, for instance works within the corporate risk solutions group, a predominantly interest rate and currency derivative group, that services UK corporates, while Ms Morrison’s day job is in debt capital markets.

Mr Lambert admits the going is tough: “Although the market is embryonic, and does not require a lot of time in terms of closing transactions and hedging out risks, it does demand a huge amount of time in terms of education, both internally and externally. But we believe the market is very interesting and exciting and are thus investing lots of time in it.”

IDB input

Fortunately for the banks, there is another constituency that has been helping them with the educational burden: the interdealer brokers (IDBs). Three of the largest IDBs have set up dedicated property teams in the past few months – ICAP has formed a property derivatives team in conjunction with property advisory firm Grafton Advisors; GFI has teamed up with CB Richard Ellis; and Tullett Prebon has set up its own dedicated team comprising three staff.

James Adam, ICAP’s head of the property derivatives team, says his group is still in the evaluation phase, going round and talking to people, sounding out appetite and trying to identify the sorts of deals and structures that are likely to take off. Henry Ann, head of new business at Tullett Prebon, says that so far his team’s work has been to speak to potential clients to increase awareness and education levels.

Lack of experience

Following the clarification from both the Inland Revenue and the FSA, Mr Ann says there has been a strong growth in interest in the market, but that in some cases, potential end-users have no experience of derivatives instruments.

“That means the education process has to begin from zero, breaking down the products into their basic form, explaining to potential users why they would want to use it and increasing their comfort levels,” he says.

The brokers’ involvement in the market is unusual, given that traditionally their role has been limited to inter-dealer rather than client-facing intermediation. But the bankers – who, in other more mature markets, might object to such moves – appear to welcome them.

Mr Lambert says: “My view on the brokers’ involvement in this market is relaxed – we are all trying to get out there and spread the word, and if they can help in doing that, so much the better. There is some nervousness about the derivatives word, and the more that are involved educating on the products, the sooner this should be overcome.”

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