Swap shop

Investors seeking exposure to UK property face a number of hurdles which are exclusive to property as an asset class.

These hurdles include the uncertain time span between identifying a possible investment and actually making the investment, the size of the transactional costs, including Stamp Duty Land Tax (SDLT), and the risk that adverse issues may come to light during an often lengthy due diligence process which cause the investment to abort.

Additionally, property is characterised by large and diverse lot sizes, potentially high environmental liabilities for a direct owner and the need for specialist expertise in managing a portfolio of such assets.
As a result, property has a reputation for illiquidity and a lower level of interest as an investment class than might otherwise be the case.

Against this background, some forward-thinking members of the property investment community joined forces in 2000 to examine the idea of developing an over-the-counter market in property total return swaps. It was hoped, with the same speed and simplicity (and lack of dealing costs) which characterise financial market swaps, that investors could obtain or hedge exposure to the UK property sector and avoid the difficulties and costs associated with direct property investment. Their organisation is the Property Derivatives Users Association (PDUA).

The PDUA is a grouping of powerful players in the industry, led by Prudential Property Investment Managers and involving banks, property companies, fund managers and the Investment Property Databank (IPD). Their vision was a market based on common-standard over-the-counter swap contract or contracts, based on existing International Swaps and Derivatives Association (ISDA) market standard terms and definitions, but supplemented as appropriate using one or more of the IPD industry indices.

Recent developments
Initial work included explaining the concept and the rationale to the Financial Services Authority and the Inland Revenue; this took time and patience, but in 2003 it began to succeed.

In the past, the concept of property swaps was dogged by uncertainty about the tax position and/or asymmetric tax treatment and an uncertain regulatory position for funds (one of the prime likely users of these instruments). Those issues have now been surmounted in a satisfactory way for index-linked swaps. Legislation is expected to be introduced in the Finance Act 2004 to bring such contracts within the regime that already exists for most types of derivative contracts, as the PDUA had suggested. At the same time, during 2003, interested banks and users had a number of meetings to discuss contractual and documentation issues, which produced
a broad measure of consensus and understanding.

Having broken the ground over the last three years, the PDUA has now established expert subgroups in key technical and support areas, focusing on contract definition, tax, regulation, accounting, education awareness and market promotion. The contract definition group will expand and finish the work done in the last six months in developing a suite of typical contract structures (on a variety of indices, including rental swaps and residential).

What is a swap?
A swap contract is a contract in which two parties agree to make and receive payments that reflect an underlying commercial position which they do not have. For example, in a fixed/floating interest rate swap, one party will agree to pay London InterBank Offered Rate (Libor) and receive a stream of fixed-rate payments. When coupled with a Libor-based floating rate loan, this synthetically produces the same position as a fixed-rate loan. The swap contract functions as if one party had borrowed money at fixed and deposited it to earn floating without it actually doing so.

How would a property index swap work?
A property index swap would work in the same way. For example, an investor with £300m of UK commercial real property exposure wishes to reduce this to £100m. As a temporary move while it sells £200m of assets, it enters into a swap with a bank, under which it agrees to pay the bank a series of payments reflecting the return on a portfolio of £200m of UK property having the characteristics of an agreed IPD index. The bank agrees to pay the investor Libor on £200m. This replicates the position of an investor which has sold and deposited cash, without any sale or deposit having been made. While the chosen index will almost certainly not behave in exactly the same way as the £200m of property which the investor wishes to sell, by choosing the right index some approximation can be achieved. Meanwhile, the investor may be content to sell off the index while keeping what may be a superior return in any event.

Likely market participants
Market participants in the early stages are likely to be funds and other property investors, banks and property companies. Initially, banks are likely to act as intermediaries, with transactions being done on a matched basis. There is reason to believe that this could change over a reasonably short timescale, as liquidity develops and speculators enter the market to add necessary liquidity. In this respect, the participation of hedge funds is a particularly exciting prospect. Indeed, there exists some US hedge funds that are interested in the opportunities in this area.

Likely uses
There are two complementary uses for these contracts: as a temporary move for investors or disinvestors who desire to deal in the underlying physical asset in due course; and those wishing to acquire or reduce exposure over a longer period as a substitute for dealing in the underlying asset. For example, property companies and investors confident of outperforming a chosen index could sell the index while retaining the physical asset, thus enhancing their return on investment. Large investors will find these contracts highly valuable as part of any tactical asset allocation exercise.

As well as the attractions in terms of time, cost and convenience, these contracts provide all market participants with a flexibility which has not previously existed. The concept has taken time to overcome scepticism or lack of understanding in a number of quarters – it has been suggested that pandas in captivity have raised entire families in less time. However, recent developments have finally brought it from the concept stage to the point of production, and this is likely to be highly welcomed over the coming months by all concerned.

Mark Daley is a finance partner at Berwin Leighton Paisner and chairs the PDUA contract definition group