The Basics

Property index based derivatives have a number of potential uses.  The following summary assumes a deep and liquid market for property derivatives allows their full potential to be realised.

 

Speed and Cheapness for Conventional Investment

Property derivatives allow investors to carry out their normal investment activities more quickly, more cheaply and with more certainty.  Derivatives can be used to gain or reduce exposure to property returns, in broadly the same way as real property.  However a derivative gives ‘generalised’ exposure to a market, rather than to a real asset.  Returns received or foregone using derivatives are based on a market index, not a specific asset.  Transactions take place with minimal legal fees and transaction taxes, so that due diligence is focused on third party credit risk rather than the complexities of actual properties.

 

Reaching Inaccessible Markets

Buying or selling  “market” returns has major implications.  Buyers can get exposure to a whole market, which is useful for investors without the scale or expertise to operate effectively in the real market.  International investors can get exposure to the entire UK market, small pension funds can access large lot size markets like shopping centres or City of London offices, while big investors can efficiently modify their exposure to sectors with small lot sizes like residential or industrial.  This general market exposure can be as large or as small as the investor wishes.

 

Managing Strategic Allocation to Amplify Real Out-performance

Trading ‘market’ exposure allows investors to do more with their physical assets.  An investor with a good track record in shopping centres could take a bigger than normal exposure to real assets in the sector, while selling excessive exposure to the sector through a derivative.  This would allow investors to enhance the out-performance gained from their management skills, keeping excess performance in tandem with the desired sector exposure.  Meanwhile an investor sensing a property downturn could sell market exposure for a time using a derivative while retaining the ownership of preferred assets; any excess performance of those assets would be kept, as would the fund’s desired structure.

 

Hedging

A company deciding to sell certain assets in the future, but worried about prices falling before then, might sell a derivative so that if prices do fall, the price drop for the actual assets is counteracted by offsetting gains on the derivative.  A similar process could be adopted to ‘hedge’ the future purchase of assets where price rises are feared.  However, for this kind of hedging the investor has to be sure that price changes affecting the assets and the market are closely correlated; if not, the hedge will not be exact.

 

Strategic Portfolio Adjustment

In an illiquid market like property, derivatives allow investors to make strategic capital movements quickly.  But for most investors active in the real market, the acquisition of physical assets to cement those exposures is likely to follow rapidly.  Index-based derivatives will track but marginally under-perform the market, due to the costs they incur, however minimal.  But the freedom to move quickly into or out of the property market, which may have very different performance prospects to other assets, means that they can still be attractive.  Smaller investors may be content to hold a ‘synthetic’ exposure to a market – because marginal underperformance could be a price worth paying for general exposure to property.

Comments