The financial crisis hit the derivatives market, and the sector linked to dealing in property was no exception, but latest available figures suggest momentum has recovered although risks remain.

From time to time, this publication looks at trends within the investment world and the new products that enable high net worth investors to get quicker, more precise exposure to hitherto hard-to-enter asset classes. Despite the problems suffered during the credit crisis, property derivatives – still a relatively young part of the market – have shown a revival in momentum, possibly presaging rosier times ahead for the battered real estate sector.

A record-breaking £100 million package of swaps has highlighted increasing volume and sophistication in the recovering property derivatives market.

The jumbo series, which gives Prudential, the insurer, long and short positions in UK commercial property sectors, highlights derivative strategies’ capacity to provide tailored exposures quickly and conveniently – even in a market as illiquid as property. It also adds further momentum after two consecutive quarters of growth.

PRUPIM, Prudential’s real estate investment arm, with over £15 billion under management, achieved its new exposures by trading total return swaps with Royal Bank of Scotland. ICAP, the brokerage, intermediated the deals between the counterparties. They require PRUPIM to pay or receive property-linked returns against sterling Libor.

Importantly, the underlying reference points to the swaps were sub-sectors of IPD’s All Property index – the UK commercial property benchmark and to date the key reference in the global property derivatives market. PRUPIM, RBS and ICAP have not disclosed a breakdown of the sub-sectors traded – other than to confirm that multiple underlyings featured in the deals. IPD’s sub-sectors comprise industrial, offices, retail and ‘other’.

Sub-sector surge?

Property derivatives players have often argued that a shift beyond trading in swaps and options on the all-property index will mark a vital step forward for the fledgling market. While the benchmark reference is a useful hedging tool and can provide broad market access, dedicated property investors need instruments that offer more specific exposures – particularly to construct relative value strategies.

“We have long believed that property specialists and institutional investors will be even more attracted to the benefits of property derivatives as liquidity grows in the sub-sectors” said Paul Rostas, Head of Property Derivatives at ICAP.

“Sub-sector property derivatives are generating a lot of demand currently as clients are now comfortable with the product and can use it to match their exact property requirements” added Alex Winward, Property Derivatives Trader at RBS.

PRUPIM’s motivation in trading the swaps was “portfolio rebalancing”, said Will Robson, Property Derivatives Director. “We take the view that this kind of activity can be a valuable device in managing risk in an institutional commercial property portfolio,” he said.

A faster pace

The sub-sector landmark transactions come as recent data shows that global trading in swaps and options on real estate indices in the third quarter of 2009 rose by more than 25 per cent from its low at the start of last year – suggesting that investors are increasingly looking to gain synthetic exposure to this key asset class after its significant declines over the past two years.

Third-quarter figures from IPD confirm that the uptick that began in the second quarter continued between July and September this year. After reaching a low in the first three months of last year, volumes rose by 17 per cent in the second quarter and a further 8 per cent in the third quarter as trading tracked by the index provider reached £762 million.

This represents a striking recovery of some 26 per cent within six months. It took the total global outstanding notional in IPD-referencing property derivatives (which includes much of the active market, particularly the key UK commercial property area, but excludes important UK retail and both US commercial and retail flows) back above £10 billion – a level it last achieved in early 2008.

Moreover, average deal size hit its highest level since the start of 2008. Third-qaurter deals averaged over £10 million each, more than twice the little more than £4 million recorded in the first and second quarters.

In addition, interbank transactions fell below half of total derivatives volume in the third quarter for the first time since the start of 2008. End-user transactions reached their highest level since Q2 last year.   

However, as a proportion of volume in physical properties the derivatives recovery has further to go. Although it has continued climbing all year, Q3’s UK ratio of a little under 25 per cent is nonetheless weaker than experienced at any point in 2008. This metric peaked at 60 per cent at the start of last year. 

After the first quarter of 2008, when quarterly derivatives trading reached an all-time high of £3.7 billion, four consecutive quarterly declines occurred.

French force

Elsewhere, trading in French property derivatives was quite robust in the third quarter, although the German market remained inactive. Banks licensed to offer contracts on IPD underlyings completed as much as £79 million of transactions in the quarter – down from the £107 million reported in the previous three months, but otherwise the highest level since the first half of 2008.

As a result, France managed to retain its double-digit share of global volume in the third quarter of last year. The deals mainly reference IPD’s Paris all offices index, the de facto French benchmark.

Only one German property derivative has traded this year, according to IPD. Transactions referencing local indices may also have gone through, though.

“Q3 volumes show a continuation of the gradual market recovery, both in absolute terms and relative to the level of direct property transactions. While the substantial reduction in the number of transactions has been balanced with an increase in average deal size, what stands out is a significantly increased market participation by end-users,” commented Nick Scarles, Chairman of the IPF Property Derivatives Interest Group (PDIG) and Group Finance Director at Grosvenor.

 “End-user activity has leapt up across the board. There are different rationales for trading now: from asset managers looking to rebalance portfolios, to investors seeking protection against further falls, while some will simply be looking for a quick property market exposure,” added Charles Harris, Senior Trader at Deutsche Bank.

“We have hit the point now where those looking at the market and using derivatives outnumber those who are not looking and do not use the market,” Mr Harris added.