The current state of the market
Seven months into 2005, the cynics are probably less cynical. Activity has been fairly decent, with aggregate deal sizes reported to be at least £600m and the level of interest has remained high, to judge by client enquiries, press reports and conferences.
The Property Derivatives Interest Group (PDIG), a sub-section of the Investment Property Forum (IPF), will formally launch in September. By then we will have the results of the PDIG/Investment Property Databank (IPD) survey of the readiness of the UK property investment market for property derivatives. Broking services have been established at Icap and GFI, two financial market broking firms, while the IPF has announced plans, in conjunction with Hermes, for a trading platform.
Why property swaps?
Investors seeking exposure to UK property have a number of hurdles to overcome:
Direct investment in property is expensive – stamp duty land tax (SDLT), survey fees and other dealing costs are in the region of 7 per cent or more – it has been estimated that this results in £500m costs per annum for the industry.
The time between identifying a possible investment and actually making the investment is uncertain.
During that time due diligence can throw up issues which result in the investment aborting.
Similar issues apply when disinvesting. There are related issues such as:
Potential environmental liabilities attaching to a direct owner.
The industry is characterised by large lot sizes.
The assets are diverse not homogeneous.
For speculative investors and those seeking to reduce exposure, it is notable that in this market, unlike most others, you cannot go short.
All these make for lower liquidity and a lower level of interest in property as an investment than would otherwise occur. Also, fund managers simply cannot execute deals sufficiently to perform the degree of tactical asset allocation they would prefer or can do in relation to other assets such as equities.
In the past, the concept of property swaps was dogged by uncertainty about the tax position or asymmetric tax treatment, and an uncertain regulatory position for funds – which are likely to be the prime users of these instruments. Those issues have now been surmounted in a satisfactory way for index-linked swaps.
Documentation is International Swaps and Derivatives Association (ISDA)-based and to a degree can adopt or copy existing market standard documentation for equity derivatives, although there are traps for the unwary. There is a concern that some of the documentation, which has been put in place for trades to date, has not adequately dealt with the specific requirements of the tax legislation or the specific characteristics of the underlying index (typically the IPD’s all properties total return index).
How would a property index swap work?
An investor with £300m of UK commercial real property exposure wishes to reduce this to £100m. As an interim 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 London Inter Bank Offered Rate (Libor), plus a margin – the level of which will vary from time to time, but so far has reportedly been in the region of 75-100 basis points – on £200m. This replicates the position of an investor that has sold and deposited cash without any sale or deposit being made. While the chosen index will almost certainly not behave exactly the same as the £200m of property 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.
The participants in the market in the early stages are largely funds and other property investors, banks and property companies. A small group of commercial banks are acting as market intermediaries. It is notable that already these banks are not merely standing in the middle between two ‘end users’, but are warehousing risk, both temporarily and longer term.
There are signs of the essential ‘virtuous circle’ by which increasing activity promotes a greater degree of confidence in liquidity, which encourages greater activity and attracts more participants. To date, the market consensus is that buyers outnumber sellers, and this has been a limiting factor. The current uncertainty about the future direction of the commercial (and indeed residential) property markets should promote more activity as more investors seek to take profits.
Structured property bonds
Mention must be made of Barclays’ issues of property income certificates, which provide, in the form of a listed eurobond, a return on investment that is linked to the IPD all properties total return index. The first of these was back in 1994, and several issues have been completed since, including £170m in December 2004. Barclays and Protego run a secondary market in these, with indicative prices displayed on Reuters. These can be viewed as a straight bond issue with an embedded property swap.
The impact on the real estate market of property derivatives
The advent of property derivatives should not herald a significant downturn in trading in actual real estate. Commercial surveyors, valuers, real estate lawyers and others who derive significant income from such trading may take comfort from the fact that the Inland Revenue, for which SDLT is an extremely attractive tax because of the ease with which it is collected, is keeping a watchful eye on the market with a view to examining whether this is so.
In the early days of consultation over the tax reforms that eventually came into effect in September 2004, the Inland Revenue had considered imposing SDLT on these contracts but was persuaded, pro tem at least, to wait and see, on the basis that this would either be neutral or positive to the SDLT take.
The emergence of a derivatives market should be complementary, encouraging investors into a relatively illiquid market because it provides an alternative and relatively quick form of entry and exit. It is fascinating to see the ingenuity being displayed by some forward thinking potential participants, and while many of the ideas being floated will fall on stony ground, some will germinate in ways that can only increase the general level of interest in real estate as an investment.
Mark Daley is a banking and capital markets partner at Berwin Leighton Paisner