Property derivatives

1
Property derivatives an introduction
2
What are derivatives?

• Synthetic exposure
• Forward contracts
• Futures
• Options and traded options
• Swaps
• Index notes

3
What are the applications?

• Speculation betting on performance
• Hedging - laying off risk of the underlying

4
Swaps

• An agreement between two parties to exchange two
  streams of payments for an agreed period of time
• Interest rate swaps
• floating for fixed
• Currency swaps
• Total return swaps
• exchange the total returns from assets or markets
  (such as equity indices) for cash or returns on
  other assets

5
Index notes

• Structured as bonds
• Income and repayment of capital linked to the
  performance of an index
• OTC or listed
• Sometimes known as structured notes

6
Property total return swaps

• Agreements between two parties to exchange
  payments based on the commercial property market
  for an agreed period of time
• Total return swaps
• exchanging all property total returns for cash or
  the returns from other assets or markets
• exchanging total returns on some component part
  of the commercial property market for the returns
  from some other component part
• Contracts for difference

7
How do swaps work?

• Crude form bank acts as broker

Office sector total returns
Investor A
Investor B
Retail sector total returns
8
How do swaps work?
Mature market form bank acts as dealer
Office sector total returns
Retail sector total returns
Investor A
Investor C
LIBOR
LIBOR
Bank X
LIBOR
LIBOR
Investor D
Investor B
Retail sector total returns
Office sector total returns
9
Uses of property swaps

• Multi asset level swaps
• swap all-property total returns for other asset
  classes
• Property sector swaps
• swap market segment returns
• International index swaps
• swap country returns
• Single property swaps
• swap one property for another

10
Alpha and basis risk

• Can property investors hedge?
• Basis risk is the probability that the portfolio
  will not produce returns in line with the index
• Long and short positions do not have perfect
  negative correlation
• Valuation lag and other technical issues add more
  risk

11
Pricing - what margin?
Office sector total returns
Investor A
Bank X
LIBOR plus margin
LIBOR plus margin
Investor B
Bank X
Retail sector total returns
12
Return expectations IPD v LIBOR

• Simple income approach
• IPF consensus 2006-8 c.7.80
• LIBOR (interest rate swap, 3 years) c.4.80
• Seller of LIBOR should pay margin of 3 less
  dealers fee

13
Margin versus tenor theoretical
Strong market buyers
Weak market sellers
14
Margin versus tenor 2005-6
Source confidential, actual deals