For ABN AMRO’s pioneering property derivatives team the value of deals is mushrooming, but it is keen that other players enter the market and create greater liquidity. Joanne Hart reports.

The physical property market is worth more than $12,000bn worldwide and most sizeable asset management institutions will have some exposure to this asset class. Yet, until recently, the opportunities to hedge against property investment were extremely limited.

Of course, asset-backed securities have been around for many years – and securitisation in the US subprime market has been the cause of untold misery in the markets over recent months. But the property derivatives market is different. It only really began a couple of years ago, it is still in its infancy, and the UK is leading the way.

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ABN AMRO’s property derivatives team: Rawle Parris, Naomi Macguire and Philip Ljubic

More specifically, ABN AMRO was the first bank to create a full-time, dedicated property derivatives desk in London back in September 2005. And it was the first bank to launch a property derivatives trade, at about the same time.

“Initially the market was about back-to-back deals [in which the bank acts like a broker, bringing buyer and seller together] but we were the first bank to actually take an outright position,” says Rawle Parris, executive director and head of ABN AMRO’s property derivatives team.

In the beginning

The bank’s debut deal was for £30m ($61m); it extended from September 2005 to December 2006 and it used the Investment Property Databank (IPD) Retail index as a reference point. “We were, in effect, the first synthetic traders of UK retail property,” says Mr Parris.

IPD creates independent market indices for the property industry. Some are generic, known as all-property indices, some are country specific, and some are sector specific. In certain countries, such as the UK, there are sub-sector indices, too.

“We also did the first sub-sector deal last year when we took a £10m position [acting as a market maker] on UK shopping centres, a sub-sector of the IPD Retail Index,” says Naomi Macguire, a quantitative analyst in the team.

Indices tend to be updated on a monthly basis and they are a respected reference point for property derivatives. The market is dominated by so-called total return swaps, which share certain characteristics with the physical property market but differ in several important respects.

First, no principal is involved so no capital is exchanged up front. Second, there are no agent fees, legal fees, stamp duty and other paraphernalia that generally accompanies property transactions.

“Total return swaps reflect the physical market in that the buyer of the trade receives [rental] income and capital growth, both reflected in the total return index. In return, he or she pays interest, analogous to a mortgage loan, which is priced at Libor plus or minus a spread,” says Ms Macguire.

Total return swaps are used by financial investors, such as hedge funds, but also by big property investors, such as Prudential.

“Some property players were calling on the banks to set up a derivatives market. Property is clearly one of the largest asset classes around, yet until recently there was no easy synthetic way of transferring direct property risk. This was clearly a big gap in the market,” says Mr Parris.

“ABN AMRO set up a property derivatives team with the express intention of moving the market on by committing capital to it and creating liquidity,” he adds.

The strategy seems to be working. Other banks are participating in the market and the value of deals is mushrooming.

“In 2005, we saw deals with a total value of £850m. Last year, this rose to £3.5bn and in the first quarter of this year alone, there were £3.5bn of deals. We expect to see transactions worth about £8bn for the whole of 2007. I think the market will continue to double in size for several years yet,” says Philip Ljubic, a director and trader in the property derivatives team.

ABN AMRO may have been a pioneer in this market but it is keen to see other players coming in, both banks and investors. “The most important thing is to develop the market and unlock latent liquidity,” explains Mr Parris.

Growth areas

Growth is expected to come from three broad areas. First, trades against the UK All-Property Index are likely to increase. Second, trades against certain sectors, such as retail, office or industrial, are likely to increase. Third, ABN AMRO anticipates more international and cross-border trades.

The bank has already done deals in France and Germany in Europe as well as Australia and Hong Kong. Last month, it joined forces with Zurcher Kantonalbank to execute the first Swiss property swap, based on the local IPD All Property Index. Looking ahead, the ABN team believes there is significant potential to develop the property derivatives market in Scandinavia, the Netherlands and the US.

“The US is about 18 months to two years behind Europe,” says Mr Ljubic. “We are undergoing a major education programme there explaining the advantages of derivatives as a cost-effective way of gaining exposure to European property.

“A lot of US funds are keen to get into European property but if they want to tap the physical market, that is expensive and time-consuming. It requires expertise on the ground and it can take months to find the right types of property. Also, if they want to get out in six months, it is not that easy. With derivatives, they can gain exposure to the market and they can move in and out much more easily,” says Mr Parris.

The ABN AMRO team believes the property market will benefit increasingly from derivatives as the sector expands and develops.

“Derivatives can be used to manage your portfolio both domestically and internationally. You may, for instance, want to increase exposure to office and reduce it to industrial. Or you may think that UK property is going down but German property is moving up. With derivatives you can adjust your exposure without having to buy and sell physical property,” says Mr Parris.

He admits liquidity could be improved but says that even in the recent subprime turmoil, deals were being done on a daily basis. And he points out that the market is still substantially more liquid than its physical equivalent. There are also signs that it is performing a similar function to derivatives in other asset classes.

“We think that, in time, property derivatives will be a key benchmark and the physical market will follow. In fact, there are early signs that that this is already starting to happen. Derivatives predicted the downturn in UK property more effectively than the consensus forecast of property experts,” says Mr Parris.

Total return swaps are one way to access this market, property-linked notes are another. The main difference between the two is that with property-linked notes, there is an exchange of principal. You issue, say, a £30m, five-year note and, over that period, the investor receives income on an annual basis. At the end of the period, there will be a capital calculation, based on the movement of the appropriate IPD index.

“Some funds prefer notes because they are more akin to investment in physical property,” says Mr Ljubic. “You pay cash for the building – like you do for a note – then you receive income from that building and then the change in capital value when you eventually sell the building,” he adds.

Market challenges

Property derivative trades vary significantly in size from as small as €5m to £500m and terms range from 12 months to five years. Unsurprisingly, the market is moving through a challenging period right now as the property market experiences more bearish conditions than it has seen in years. Mr Ljubic points out that this is precisely the sort of environment in which property investors should be looking more closely at derivatives.

“Yield compression over the past few years has made a lot of property investments look good. Going forward, with yield compression running out of steam, and in some cases reversing, property values will be delivered by superior asset and risk management. Employing property derivatives strategies is one way managers and owners can strive for that extra value.

“Property derivatives are risk management tools. We all know the market is soft at the moment, but there are lots of different views about how much prices are likely to fall. You may think they will go down by 1% or 15%. Obviously there is value to be had in those two views,” says Mr Ljubic.

Sentiment is such at the moment that many of the prices under discussion in the derivatives market are below Libor.

“Prices obviously reflect sentiment and the derivatives market at the moment is very bearish,” says Mr Parris. “Synthetic buyers can come in and buy at 2% to 3% below funding levels. So if you are a physical buyer and you were previously unsure about the value in this market, you may take a second look and decide now is the time to buy because it is so cheap relative to the physical market.”

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