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1 International topics Current Issues June 1, 7 Property derivatives marching across Europe Property derivatives broaden the investment universe. They allow investors to gain exposure to real estate and are therefore a sensible alternative to conventional indirect investment vehicles. Advantages of the product suggest continuing strong momentum. For a counterparty, property derivatives provide a flexible method to invest in a very broad index linked real estate portfolio at relatively low cost. Due to the advantages for both buyers and sellers, markets in property derivatives are poised to be a success story. Buzz in UK s property derivatives market. Although property derivatives have been under discussion in theory and in practice for over 15 years, a significant market developed only in the last three years: in early 7, the volume of property derivatives traded reached GBP 7.6 bn. The figure was thus more than six times higher than at the end of 5. We expect UK trading to reach GBP 1 bn in 1. Authors Tobias Just Deutsche Bank Research Jürgen Feil Deutsche Bank Global Markets Editor Hans-Joachim Frank Technical Assistant Sabine Berger Deutsche Bank Research Frankfurt am Main Germany Internet: Fax: Managing Director Norbert Walter Germany lags behind the UK. Functioning markets for property derivatives are likely to develop over the next few years in the Netherlands, Sweden and France. We believe that the market development in Germany will show less momentum as property indices available so far cover only part of the German property market. We expect real estate indexing to become more representative over time and forecast the volume of derivatives trade to reach roughly EUR 5 bn by 1. Real estate is no commodity. Real estate comes in all shapes and sizes. Hedging real estate risks is therefore more difficult than hedging stocks and commodities. Furthermore, there are no arbitrage opportunities between the underlying real estate markets and the derivatives. Thus, the upward potential of real estate derivatives will be much less pronounced than that of other types of derivatives. As real estate accounts for the bulk of national wealth, however, the property derivatives market is still expected to show rapid growth despite the limited derivative functions. Rapid growth in the UK Property derivatives based on the IPD-Index (GBP billion) Notional value per quarter Q Q3 Q 5 Q 5 Cumulative notional value Q3 5 Q 5 6 The available annual data for has been distributed evenly across the four quarters. Q 6 Q3 6 Q Source: IPD

2 Current Issues Increasing integration of real-estate and capital markets Uninterrupted growth Notional value of derivatives (USD trilion) 5 5 Growth: % p.a OTC (Over the counter) = Exchange-traded OTC Exchange traded Source: BIS 1 Introductory remarks The increasing integration of real estate and capital markets brings mutual benefits. This is shown by important developments in Germany and many other countries. Many private equity investors are now heavily invested in German real estate; securitisations on residential and commercial real estate are achieving increasing growth, and in 6 alone real estate companies came to the market, with their investment focus on Germany. As a matter of fact, this dynamic development reached a peak for the time being when the Bundestag and the Bundesrat adopted the REIT law at the end of March. Peak for the time being? This raises the question of the next milestones on the way up. Besides the actual establishment of a liquid REIT market, a well functioning property derivatives market will likely be the next milestone. In this context, two factors are crucial: first, derivative products have experienced increased enthusiasm over the last few years. The total outstanding notional traded volume at the end of 6 was already close to USD 5 trillion, i.e. roughly ten times 6 global GDP. Around 8% of total volume was traded over-the-counter. Second, the exposure of derivatives to real estate still plays a negligible role. This is surprising as real estate accounts for the largest share in the assets of a national economy by far; furthermore, real estate is subject to specific risks which would argue for hedging. The fact that the segment is lagging behind is attributable to two main factors: (a) Derivatives have to meet high demands on transparency, standardisation and above all the reliability of databases. In many cases, real estate market databases did not fully meet requirements in the past. (b) Both the financial sector and science started to consider property derivatives at a relatively late stage. 1 Initial efforts in the early 199s, e.g. at the London Futures and Options Exchange (London Fox), quickly came to an end. In early 5, a new stage set in that saw the United Kingdom beat continental Europe to the punch yet again. The first real estate swap of GBP m, which was arranged by Deutsche Bank and Eurohypo, was soon followed by further transactions. By the end of 7, over trades were executed with a cumulative notional value exceeding GBP 7.6 bn. In the following chapters, we point out why property derivatives are an enhancement for real estate investment markets and why existing investment products including REITs are unable to fully substitute derivatives. In our opinion, the market weakness of the early 199s is unlikely to repeat itself. Looking forward, the limits and remaining barriers to the new investment vehicle will not prevent the market from developing. Characteristics of property derivatives Derivatives are financial instruments whose return and value are based on the value of an underlying asset, e.g. commodities, stocks or real estate (see Hull, 6). In practice, three types of derivatives have so far been relevant for real estate: swaps, certificates/bonds and options. 1 The seminal publication was the discussion paper by Case, Shiller and Weiss (1993). In the meantime, a good overview has also been provided in German publications (e.g. Hübner,, and Plewka, ). Major terms are explained at the end of our analysis in a glossary. June 1, 7

3 Property derivatives marching across Europe Specimen investment appraisal Determine the individual price (X%) that the party expects to receive in exchange for his property market return. Market interest rates Zero- Rates 3//8 3.9%.96 = DF1 3//9.%.9 = DF 3//1.3%.88 = DF3 Subjective forecasts of the DIX Party 1 Party 7 6.% 3.% 8 9.%.% 9 9.% 5.% Individually fair, fixed rate of return for a 3-year Total Return Swap a) Cash Flows Party pays 3//7 X% DIX Return 7 3//7 X% DIX Return 8 3//7 X% DIX Return 9 DIX 7 DIX 8 DIX 9 X% X% X% b) Net present value of cashflows Party pays Party receives X% DF1 DIX 7 DF1 X% DF DIX 8 DF X% DF3 DIX 9 DF3 (DIX7 DF1 ) + (DIX8 DF ) + (DIX9 DF3 ) DF1 + DF + DF3 Discount factors Party receives c) Calculation of individually fair, fixed rate of return The net present value of the swap is zero when the contract is concluded => Both sides of the swap equation must be of equal value ( DIX7 DF1 ) + (DIX8 DF ) + (DIX9 DF3 ) = ( X% DF1 ) + ( X% DF ) + ( X% DF3 ) d) Calculation of the individually fair, fixed rate of return based on Party 1 s forecasts X% = 8% and Party s forecasts X% = % =X% With a currently quoted fixed rate of return of 5%, party 1 could buy property exposure more cheaply than his forecasts suggest. Party, by contrast, could sell property exposure at a higher price than expected. Types of derivatives Real estate swap deals so far account for the major share in derivative property transactions. In swap deals, the contracting parties swap cashflows, so to speak, and thus reduce their risk. For example, an investor who has a large real estate portfolio is able to reduce his/her exposure by entering into a total return swap. With such a deal he or she locks in a fixed or floating rate of interest paid regularly. For example, the floating rate could be linked to an interbank rate (Euribor or Libor). In exchange, the investor pays the counterparty the movements in a Total Returns Property Index. In the event of a weakening real estate market the investor can stabilise the returns on his portfolio as the additional cashflow is kept relatively constant by the fixed rate (or Euribor/Libor plus premium). In such a situation, he has to pay a relatively low property return to the counterparty. The precise structure of these transactions is depicted in the box on p. 7, and chart shows how various market expectations lead to the establishment of the market: two participants with different expectations calculate a fair price for themselves at which they would agree to sell their real estate risk against a fixed rate or make a further transaction. Real estate bonds are based on the same idea. They are based on a certificate reflecting by a property index. A client may purchase bonds to secure payouts over the maturity which are reflected by the index. Based on this instrument the client makes a real estate investment linked to the index. Furthermore, first experience is being gathered with real estate index options. Options give the client the right to carry out a transaction at a later date at a price agreed. A call option may, for example, give the client the right to purchase a property index-linked product at the price previously agreed upon. Call options give the investor the possibility to benefit from a rising market. If the market drops the investor does not exercise the option and only loses the premium. Conversely, an investor buying a put option can bet on a falling market, for he or she buys the right to sell an index-linked product at the price agreed. Besides the established products mentioned, forward contracts are possible. Here, the contracting parties commit themselves to carrying out a later transaction at the conditions agreed. Trading in quantos has also increased. 3 The products discussed are based directly on a property index, and are therefore linked to outright real estate investment. Alternatively, derivatives may be launched on real estate stocks or REITs. Functions of derivatives As derivatives open up a range of investment alternatives, their functions are worth considering: Hedging function: Many people regard derivatives as speculative and risky investments. However, the major function of derivatives is the hedging of risks. As in other asset classes, real estate risks may be divided into a general market risk and an object risk. In the case of the existing property derivatives, hedging operations are focused on market risks. For the hedging of object risks, an isolated object derivative is required. This is unlikely to lead to large products, though, as the moral hazard 3 A quanto is a derivative in which the underlying asset is denominated in a different currency. June 1, 7 3

4 Current Issues Conclusions about return expectations IPD total return (all types of property) and implicit forward returns (%) Return expectations derived from pricing mechanisms Sources: IPD, Deutsche Bank Efficient hedging between portfolio and index return 5 3 problem would be substantial. After the conclusion of the contract, homeowners would have little incentive to maintain their homes. Investment and speculation function: Besides the risk reduction for real estate investors, the counterparty is given the opportunity to invest in real estate without large transaction cost. A swap is a tool where investors receive a real estate return in exchange for the coupon payment. As each speculator requires a counterparty for his speculation, property derivatives may therefore even reduce the amplitude of speculative price movements on the underlying real estate markets (see Case, Shiller and Weiss, 1993). Pricing function: Options, forwards and swaps have one thing in common: the willingness to pay for these products allows investors to draw conclusions about the implicit market expectation of the participants. Mean expectations of market participants with regard to their underlying return expectations can therefore be assessed. Furthermore, calculation tools have been designed to extract the distribution of market expectations of all parties involved from the (implied) volatilities of options. These are a good basis for the development of suitable benchmarks for forecasts. In addition, these yardsticks reflect all information available for exchange-traded vehicles on a day-today basis. This also serves the participants on the underlying real estate markets. Arbitrage function: For the valuation of derivatives, a stock index can be mirrored on the spot market. This opens the possibility for arbitrage transactions. As it is impossible to purchase property index linked real estate on the spot market, the arbitrage function is not available for most property derivatives. Functioning of a Total Return Swap Currently, the highest share of property derivatives trades is accounted for by Total Return Swaps on the IPD Index. 5 The functioning of such swaps is shown in the box on p. 7. The transaction here is based on the Deutscher Immobilien Index (DIX) of IPD. In this example the investor has a commercial real estate portfolio worth EUR 1 m. In the past, the development of the value of this portfolio correlated closely with that of the DIX. In his baseline scenario, the investor expects a continuing economic upswing in Germany which from 7 will also allow clearly positive Total Returns of the DIX (and thus of his correlated portfolio). Nevertheless, the investor is concerned about the developments in the US and some European housing markets and in his risk scenario. Therefore, he has to consider a slowdown in growth and also low total returns on the German commercial real estate markets. In this situation, his bank offers him a Total Return Swap on the DIX with a 3-year maturity and a fixed coupon of 5.5%. To receive this coupon he pays the annual Total Return of the DIX to the bank. On the basis of this swap, his net return consists of three components: he generates the real estate return of his portfolio (7=5%), 5 Derivatives on single objects also imply transfer of management. This involves higher transaction costs. The moral hazard problem specific to owner occupied housing is dealt with in detail by Shiller and Weiss (). The IPD Index is provided by Investment Property Databank Ltd, a research company. It is a valuation-based Total Return Index. June 1, 7

5 Property derivatives marching across Europe Pros and cons of property derivatives Advantages Direct investment in property High level of diversification possible Highly flexible instrument Rapid investment possible Low transaction costs Low-volume entry possible Cross-border transactions possible Disadvantages Heavily dependent on the quality of the index Little experience to date Insufficient liquidity in many markets Availability of data Limited suitability for buy and hold strategies Outperformance achievable only via financial engineering Source: Deutsche Bank Derivatives: composition of index is key! Derivatives are different from REITs receives the fixed rate (7=5.5%) from the bank according to the contract, but in exchange has to pay the DIX Return (7=5.6%). He would thus achieve a Total Return of.9% net (5%+5.5%-5.6%). As this transaction is above all a hedging transaction for him, his net return in the baseline scenario is lower than his real estate return. The value of the hedging operation becomes apparent in the risk scenario. Here, his real estate return is much lower than the potential net return. The risk, captured by the differential between the return in the baseline scenario and in the risk scenario, is reduced strongly by the derivative. This effect is of major importance especially to institutional investors who have held out the prospect of a minimum return to their clients. Furthermore, an optimum investment decision can be calculated if the investor is able to attach subjective probabilities to the scenarios. In the example, the investor benefits from the swap if the probability of the risk scenario is considered to be over %. If it is lower, the swap does not pay at least with a view to the respective return expectations. Property derivatives offer plenty of advantages to investors on both sides of the market. They are flexible investment vehicles, and they give investors the opportunity to quickly adjust their portfolio to a new macroeconomic environment by purchasing or selling. In general, property derivatives can reflect a direct real estate asset investment very well, as they are linked to a property index which captures (in sum) a large part of real estate value developments. This is the major advantage: in a Total Return Swap on, for instance, the British IPD Index, funds are invested in a portfolio of over 1, real estate assets at a market value of close to GBP bn. This offers an opportunity for a strongly diversified real estate investment and alternatively allows players to adjust a real estate investment for the general market risk by means of a swap. Nevertheless, property derivatives do not (yet) meet all needs of real estate investors. In many markets there are no satisfactory indices yet on which derivatives may be based. 6 Investors should always watch the composition of indices even if they are considered suitable. For example, residential real estate accounts for only 8% of the IPD Index for Germany while a large share is accounted for by holdings of open-end real-estate funds. Thus, a property derivative on the Index for Germany is above all a commercial property derivative. Furthermore, property derivatives are still in their infancy so the market is not very liquid yet and it still needs to gather experience. Finally, derivatives are marked by the fact that investors can only hedge the general market risk and benefit from general market opportunities. One opportunity for outperformance, promising an attractive direct investment, is leverage products that also started to be traded. 7 Comparison with other indirect real estate products These advantages and disadvantages also allow us to make a direct comparison with other real estate asset classes. Derivatives provide a new mix of the typical characteristics of real estate investments. Given their broad, implicit diversification, for example, derivatives are different from REITs, which are more specialised as a rule. 6 7 An appropriate index has to represent the market, must be reproducible and transparent and have the highest frequency possible. Furthermore, the index data have to remain in place; past data must not be revised to ensure that the price calculations of market players may be based on stable parameters (Plewka, 3). A broad and liquid market leads to even more leverage products. These also allow above-average yields at rising risk. June 1, 7 5

6 Current Issues Furthermore, derivatives (if they are not REIT-based derivatives) are not correlated to the stock markets. Thus it is not a question of whether REITs or derivatives are a more attractive investment; it depends on the specific needs of investors. Derivatives on the basis of their composition have a hedging function for one side of the market, though. No other real estate investment tool allows an adjustment for the general market risk. Comparison with existing forms of property investment Directly held property Open-ended property funds Closed-ended property funds Speciality funds REITs Property derivatives Correlation with other asset classes Unlimited divisibility Low Moderate depending on property ratio Low Low Correlated with equities No Yes No No Yes Possible Tradability Poor Good Poor Poor Level of specialisation Information efficiency Transaction costs Main risk Main investor group Very good (ideally) Low Possible High Low High High High Very low Low Low Very low Moderate High High Very high High Very high Moderate Low Low Liquidity risk/cluster risk High net worth individuals, institutionals Liquidity risk Private investors Liquidity risk/cluster risk High net worth private investors Cluster risk Institutional investors Stock market volatility Institutional investors Liquidity (still) Institutional investors Sources: ZEW/ebs, Deutsche Bank 5 Positive impact on the economy Great advantages for private investors Case, Shiller and Weiss (1993) even come to the conclusion that derivatives have a strong economic significance. They expect an increasing number of standardised buildings and, as a result, a potential sustained decline in rents. As real estate investments may concentrate less on direct real estate holdings, speculative price movements on the real estate markets are reduced, which smoothes out the business cycle. Although the argumentation in support of these impacts makes sense, the extent of the effects is likely to remain limited. This applies all the more as exaggerated price movements cannot be ruled out for property derivatives, either the smoothing effect on the real estate market would in such case be countered by an accentuation on the capital market. However, some empirical studies show that derivatives can significantly reduce the overall risk in mixed portfolios. Especially low-income households for whom a real estate investment always means a considerable cluster risk can strongly improve their riskreturn position. 8 8 See e.g. Iacoviello and Ortalo-Magné (3) as well as Englund, Hwang and Quigley (). Both studies analyse the hypothetical effects of derivatives on owner-occupied property. 6 June 1, 7

7 Property derivatives marching across Europe Case study: Hedging a property portfolio using a DIX Total Return Swap Current market value of the portfolio: EUR 1,, Correlation of portfolio with the index: 85% Total Return of the portfolio (capital gain/loss + rent) Baseline scenario Risk scenario 7 5.% 7.% 8 8.% 8-1.% 9 7.% 9 3.% Total Return of the DIX property index Baseline scenario Risk scenario 7 5.6% 7.% 8 7.% 8 -.1% 9 7.% 9 1.5% Conclusion of Total Return Swaps to hedge property risk: Term: 3 years Customer pays: DIX annual Total Return Customer receives: : 5.5% per annum Investor DIX annual Total Return Fixed rate of return 5.5% Change in value Rental income Property Net return on property dealings and hedging Baseline scenario Risk scenario Comparison of spreads between risk and baseline scenarios Property Swap Net Return Property Swap Net Return Property Net Return Total Return falls slightly Return patently positive Marked reduction in risk in baseline scenario downside scenario Spread between Total Returns in the Total Return % Total Return % risk and baseline scenario (%-points) Property Net Return Source: Deutsche Bank Property Net Return Source: Deutsche Bank Property Net Return Source: Deutsche Bank 6 June 1, 7 7

8 Current Issues Many potential application areas Rapid growth in the UK Property derivatives based on the IPD Index (GBP billion) Notional value per quarter Cumulative notional value Q3 5 Q3 5 6 Q3 6 7 The available annual data for has been distributed evenly across the four quarters. Source: IPD Users of property derivatives The advantages and disadvantages outlined above as well as the functions of derivatives lead to the conclusion that property derivatives are attractive for both private and institutional investors. Institutional investors can diversify their real estate exposure by going long. Thus, they either replace direct real estate investments or existing indirect investments such as speciality funds. The counterparties, real estate funds, can reduce their real estate risk by going short. Furthermore, a short position provides an opportunity to finance a property without additional equity or external finance. In addition, cross-border and cross-sectoral derivatives are an easy way to hedge regional and sectoral risks. The products placed have so far concentrated on institutional investors. This is due to the fact that they are more familiar with capital market products and have a more open attitude towards them. As many private investors have a higher real estate ratio than most institutional investors, however, the financial incentive for private investors is even stronger than for institutional investors. The real estate ratio especially of young households with high borrowing in many cases exceeds 1% of their net assets; thus, hedging deals against this cluster risk are highly recommendable. 9 Furthermore, those living in the rented sector can simply invest in real estate by taking a long position with a derivative. Such a position could even make it possible for them to purchase the call if they want to buy property at a later date and want to maintain their purchasing power in terms of their average property value. Description of the market s dynamics Property derivatives have been propagated for around 15 years. Although they failed to become established in their first incarnations in the 199s the UK market has been hotting up appreciably for the last three years. In Europe, the UK is (once again) the pacesetter. It therefore makes sense to start by examining developments there. Experience and market outlook in the UK At the start of 7 the value of property derivatives based on the IPD Index reached a cumulative notional of some GBP 7.6 bn. In 6 alone there were nearly 36 transactions in all. The number of deals thus rose by a factor of 5 compared with the previous year, while the volume actually increased more than sixfold in the space of twelve months. The average volume per transaction of some GBP 16 m was also up on the pre-year figure, but still significantly lower than the reported reading for (see chart 8). Besides the exponential growth track on which the market finds itself there are three observations that need to be made: firstly, one transaction can result in several interbank transactions, all of which are reported to the IPD. The market volume stated here is thus not a precise measure of the demand of end-consumers. Secondly, it should be noted that the only transactions referred to here are those based on the IPD Index. Moreover, it is at least conceivable that there are also transactions which are not reported to the IPD. Thirdly, 7 saw the registered trading volume for property derivatives reach its highest level ever. The cumulative notional climbed in 7 to more than GBP 7.6 bn. Since some deals 9 The first theoretical analyses on property derivatives always focused on the risks of the housing market for private investors. 8 June 1, 7

9 Property derivatives marching across Europe More deals on a slightly smaller scale Property derivatives based on the IPD Index Number of contracts in year (left) Average deal size, GDP m (right) Development level of IPD property indices Market coverage of index (%) Source: IPD Is the index ready for derivatives? AU 5 Ready to a degree AT 3 Ready to a degree CA 5 Ready DK 1 Ready FI 6 Ready FR 5 Ready DE 3 Ready IE 79 Ready IT Ready to a degree JP 1 Not yet ready NL 6 Ready NO 7 Ready PO 51 Ready ES 8 Ready SA 6 Ready SE 3 Ready CH 35 Ready to a degree UK 5 Ready Source: IPD, Februar 7 9 have expired in the meantime, the volume of outstanding notionals did not increase. How will the story continue? It is likely that the UK market continues to trend upwards. And not only because of the above-mentioned fundamental advantages of the instrument, for these already existed ten years ago. The more important factor is that there are now 17 banks that have acquired licences for the IPD Index and are authorised to deal in derivatives. In addition, the international consultancies are building up derivatives expertise and information is being disseminated via professional conferences and seminars. This results in the very rapid sharing of knowledge about the new instrument, and this will boost demand. Some market observers believe it is already possible that the growth story of other derivatives markets is transferable and that accordingly the volume of the derivatives market could exceed the value of the underlying property in a few years. They forecast that property derivatives worth GBP 3, bn for the UK alone could then expect to be traded. 1 This forecast is, however, wildly exaggerated. Unlike interest rates or oil, property is highly heterogeneous, which means that the hedging function of property derivatives is significantly smaller than for commodities, for example. Moreover, property derivatives have no meaningful arbitrage function, because it is impossible to replicate the property index with actual property. This makes pricing difficult. All the same, the property derivatives market can be expected to sustain its strong growth. A realistic forecast is that the market volume will already have exceeded GBP 1 billion by the end of the decade. Which countries will follow? Other European countries look set to follow in the UK s footsteps. The success of a future derivatives market is largely dependent on four factors: Firstly, a suitable property index with sufficient data history must be available. This index should cover a large section of the relevant market and be divisible into sub-indices (e.g. office, residential, retail outlet and/or regional sub-indices). IPD s current assessment is that in the meantime most of its own country indices are suitable for derivatives trading six months ago still half of the indices were considered unsuitable. Apart from the UK, the countries with particularly conducive conditions are Ireland and the Netherlands. These countries already offer sufficiently long IPD data series, the index provides sufficient market coverage and in the case of Ireland there are also quarterly figures available. 11 Secondly, experience with capital market vehicles, especially in connection with property deals, should act as a catalyst. For example, the market value of real estate stock corporations and/or REITs could serve as a proxy for this. In this regard apart from the UK we can once again cite not only the Netherlands and Ireland, but also France and Spain. Germany, with its introduction of REITs in 7, has managed to qualify by the skin of its teeth, so-to-speak. Thirdly, it is specifically in markets with high transaction costs that derivatives are an interesting proposition. In the residential market 1 See quotes in Exporeal (7). 11 IPD also considers the indices for Denmark, Finland, France, Germany, Portugal and Spain to be suitable. June 1, 7 9

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