14 August 2006
Property derivatives have become established as a product used by the property industry and by banks. Lawyers who have acted on transactions involving property derivatives or who expect to do so are now considering how much work they will generate as the market develops.
It is often said that real property is the most prominent and most valuable asset without a developed derivatives market. The total investment in UK commercial property exceeded £50bn for the first time in 2005. Given these volumes of real property that are traded, derivative transactions appear to provide a useful alternative to them.
A property derivative transaction enables an investor to take a view on the property market without owning a property. In its most common form, an investor will make payments to, or receive payments from, a counterparty, depending on the amount by which the commercial property market as a whole rises or falls, hence a market-based return without the risk and inconvenience inherent in an individual property is achieved. The transactions combine fast execution and low transaction costs, so there are obvious benefits for investors. However, as it is difficult to see significant revenue for law firms in documenting straightforward trades, lawyers are seeking other opportunities.
Investors entering this market are certainly able to put together trades without the help of a lawyer. The most broadly used documents follow International Swaps and Derivatives Association (ISDA) documentation - therefore sophisticated clients can perform most of the documentation work in-house.
There are, however, opportunities for lawyers outside documentation. For example, clients may ask for or expect strategic advice in relation to deals and their portfolios, while there is also the opportunity for lawyers to bring together clients who may be interested in trading of this type. Questions may also arise as to the extent that this type of trading and its offshoots will form traditional physical property transactions and the extent to which property derivatives will form part of larger structured transactions or traditional property finance transactions. There is work for real estate lawyers who have the industry knowledge and contacts and for financing lawyers who have expertise in this type of documentation.
Historically the regulatory and tax treatment of contracts of this type was somewhat uncertain. However, the regulatory environment has changed in recent years.
First, from 2002, life assurance companies were permitted to enter into derivative transactions. As significant holders of real estate assets these companies are natural parties to property derivative trades in order to hedge or otherwise manage their exposures. Second, a new set of rules for the taxation of profits and losses of companies from certain financial installments, including derivatives, was introduced by the Finance Act 2002. Where the rules apply taxation is aligned with the accounting treatment.
With the removal of specific obstacles to efficient trading, the market is gaining momentum. The Property Derivatives Interest Group was established in September last year by the Investment Property Forum, with the stated aim of improving awareness of the market and encouraging best practice. Meanwhile, a property derivatives trading forum led by Hermes Real Estate has given potential participants in the market an opportunity to trade on a virtual basis. The forum has met four times already, most recently in May, and representatives from organisations including investors, banks and agents have seen and debated how to establish prices for specific trades. A number of banks now have dedicated trading desks and are increasingly taking principal positions on trades. Some believe the property derivatives market could be worth approximately £20bn a year, so it is a market that lawyers will wish to follow closely.
The benefits of property derivatives flow directly from their structure and flexibility. There is no strict definition of a property derivative and any contract deriving its value from underlying real property is a property derivative contract.
However, one structure has become standard: the index total return swap. This is effectively the same transaction as a swap based on interest rates, but instead provides for the exchange of cashflows based on the value of commercial property. Unlike, for example, a bond issue paying a return by reference to property values, these transactions have no significant start-up costs and so are available to small as well as large investors. They only have two parties, so commercial terms can be agreed quickly. They are flexible as the parties can include or exclude whatever terms they choose. And because the technology is borrowed from the mature swaps market, the standard ISDA documentation is available and requires little adaptation.
Supporters of the market are most obviously attracted to the time and cost of a derivative transaction relative to an acquisition of a physical commercial property. Time spent marketing and documenting a commercial property sale is measured in months rather than weeks. By convention, the 'round trip' costs of stamp duty, professional fees, sales commissions and registration fees on purchasing and then selling a property are estimated to be 8 per cent. A derivatives trade can be effected over the telephone, attracts no stamp duty and is relatively easy to document.
Another significant attraction is the ability to take a 'short' position in relation to property. Shorting, or the selling of an asset not then owned in the expectation of a fall in its value, is a commonly used tool in debt and equity markets. Traditionally in the property market an investor expecting a fall in prices could choose not to purchase assets and thereby avoid losing money, but could not make money. A continued #+ continued property derivative enables an investor to make a profit in a falling, or even neutral, market. On the same basis, investors with large portfolios are able to hedge their exposure to falls in prices by entering into derivatives that will pay to them in these circumstances.
Away from the more straightforward trades, property derivatives provide sophisticated tools, borrowing from the sophistication of existing derivative markets. This is an area where financing lawyers have something to offer by introducing existing technology to a new market. Investors can isolate the performance of their investment from general market cycles by selling off exposure to gains or losses from the market, leaving a return based purely on the investment itself - in other words, a return only if that investment has beaten the market.
It is possible to perform sub-sector trades so that an investor that owns significant amounts of retail property, but believes that sector will underperform the industrial sector, could swap its exposure from retail to industrial using a derivative trade. Hence the structures can very efficiently permit portfolio rebalancing. For developers, structures exist that reduce development risk and their cost of funding. As with all things, the question for participants is the pricing.
Real estate lawyers have integrated successfully complex co-investment and financing structures into their practices. Property derivatives are part of this trend and are another product on which real estate and financing lawyers will work together. As has previously been the case in this market, the greatest success is likely to be achieved by those practitioners who take the lead in bringing clients towards more cost-effective and efficient structures that work across the property, finance and corporate disciplines. Yet another opportunity has arisen.