List of Appendices
List of Figures
List of Tables
List of Abbreviations
Abstract
1 Problem outline and significance
1.1 Purpose and Motivation
1.2 Research Question
1.3 Method
1.4 Disposition
1.4 Terminology
2 Rationales for Property Derivatives
2.1 Principles of the Property Derivative Market
2.2 Advantages
2.3 Disadvantages
2.4 Users in the Market
3 Basic Property Derivative Instruments
3.1 Property Swaps
3.2 Property Forwards
3.3 Property Futures
3.4 Property Options
4 Underlying Indices
4.1 Characteristics of Indices
4.2 Important International Indices
4.3 Indices in Austria
5 Pricing of Property Derivatives
5.1 Pricing Models for Property Derivatives
5.2 Pricing influencing assumptions
6 Property Derivatives in Austria
6.1 Austrian Property Market
6.2 Austrian Property Derivatives Market
6.3 Valuation of a Property Swap
7 Conclusion and suggestions
Bibliography
Appendix
Appendix 1: Interview mit Hr. Höchtl
Appendix 2: Risks of derivatives
Appendix 3: Comparison of different kinds of property investments
Appendix 4: Explanation of systematic risk and into the un-systematic risk
Appendix 5: Criteria for underlying indices
Appendix 6: Available IPD indices all over the world
Appendix 7: Full databank profiles for the IPD countries
Appendix 8: List of banks and brokers holding an IPD license
Appendix 9: Evaluation of a 5-year property swap (fixed leg < floating leg)
Appendix 10: Evaluation of a 5-year property swap (fixed leg > floating leg)
Figure 1: Structure of the paper
Figure 2: Monthly annualized turnover rates of single family properties versus turnover rates of stocks in the US
Figure 3: Property derivatives based on the IPD index (GBP billion)
Figure 4: How a property swap works
Figure 5: Payoff diagram of a forward contract with a strike price of 100
Figure 6: Payoffs of the four basic option strategies
Figure 7: Risks of derivatives
Figure 8: Systematic and non-systematic risk
Figure 9: Available IPD indices all over the world
Figure 10: Global IPD indices as at end-2008
Table 1: Databank profiles for the IPD countries
Table 2: YoY-performance with different maturities
Table 3: GBP discount rates, present values of coupons and Calender Forwards
Table 4: Calender Forwards, DiscProperty and Property Indices
Table 5: Evaluation of a 5-year property swap (fixed led = floating leg)
Table 6: Comparison of different kinds of property investments
Table 7: Full databank profiles for the IPD countries
Table 8: Evaluation of a 5-year property swap (fixed leg < floating leg)
Table 9: Evaluation of a 5-year property swap (fixed leg > floating leg)
Abbildung in dieser Leseprobe nicht enthalten
Nowadays all participants of real estate and financial markets have to know about property derivatives. Everyone who wants to get basic know-how about property derivatives will find a good groundwork with the paper.
It paper offers an overview of the rationalities for property derivatives with its ad- vantages and disadvantages as well as its users. Furthermore the basic property derivative instruments, such as: property swaps, property forwards, property fu- tures and property options are explained. The characteristics of underlying indices and most favorite indices are mentioned as well. Also a basic insight about differ- ent pricing models is given. In addition the Austrian property derivatives market and the Austrian property market are outlined and compared with the market of the United Kingdom. Finally a valuation of a property swap on the UK All Property in- dex is explained in detail.
The paper ends with a summary of the main outcomes and by mentioning further topics that have to be discussed in order to get an overall picture of the Austrian property derivatives market. Also some suggestions for developing a property derivatives market in Austria are mentioned.
“Real Estate is not only a vital part of the economy, involving tens of thousands of businesses and jobs worldwide, but also the primary financial assets of many companies and citizens. [...] In fact, no other asset class reaches the value of real estate.”1
Actually, there are three different ways of investing in real estate. The two tradi- tional ways are direct investments, for example by purchasing houses, or indirect investments, for example through real estate companies, listed or non-listed prop- erty funds. The third and newest way is investing by buying or selling property de- rivatives.
Some characteristics hamper the above mentioned traditional ways of investing in real estate. Properties are very heterogeneous and fixed located assets, which are typically not fungible and have a long-term nature of the holding management. Furthermore, because of the lack of liquidity, other important characteristics ap- pear: real estate trading is costly, time-consuming and less frequent in comparison to other investment classes. These characteristics lead to infrequent trading and cause difficulties when comparing the prices of the properties on a regular basis. Due to infrequent trading, measurement of property investment performance is more difficult than measurement of investment performance of financial assets.2
Because of these facts, trading with physical real estate involves different obstacles and is therefore not possible for everyone. Property derivatives overcome these shortcomings. This financial instrument provides the opportunity to trade real estate without investing in a physical asset and so allows more flexibility.
To implement property derivatives three fundamental requirements for derivatives have to be fulfilled by the property market: first, the size of the market has to be large enough that demand to buy and sell exposure exists sufficiently to make a derivatives market desirable. Second, there is a need to invest or hedge due to the fact that risk in sense of volatile returns is present. The third fundamental requirement is the existence of a credible index that is accepted as a common benchmark in order to have a reference for payoffs.3
Over the last few years there has been increased activity in developing derivative instruments. Nevertheless the property derivatives market is still lagging behind in volume of trading and liquidity, although the physical property markets represent a large proportion of total wealth in developed countries.4
Two formal prerequisites are required for financial institutions in Austria to establish a property derivative. First, the financial institutions need permission to conduct bank business in accordance with Art.1 §1 Z1-6 BWG. Second, a license for trading on an appropriate index is necessary.
The main research question of this paper is: “How do property derivatives work and which advantages do they have?” This question is answered in the chapters two to five where the necessary parts to establish property derivatives and their advantages in comparison with other real estate investments are mentioned.
The secondary questions are: “Is there a property derivatives market in Austria or even a potential?”, and “For whom can a property derivative make sense and where is the state-of the-art in property derivative knowledge in Austria?” The first question is answered in chapter six and seven. The method to find out the state-of the-art of knowledge is identified in chapter seven.
This paper gives an introduction into the basic knowledge concerning property de- rivatives. The theoretical part of this paper is based on the acquired information from a variety of sources. Therefore a number of journal articles and working pa- pers, publicly available reports and informational portals on the internet were used. Unfortunately only one book which exclusively deals with property derivatives was identified. In addition, Mr. Höchtl who is a founding member of the European Fo- rum of Property Derivatives was interviewed. The protocol of the interview can be found in appendix 1.
Afterwards the single chapters are explained and illustrated in figure 1. This figure gives a good overview about the structure of this paper.
Abbildung in dieser Leseprobe nicht enthalten
Figure 1: Structure of the paper5
Chapter two (Rationales for Property Derivatives) deals with the basis for the sub- sequent chapters and the principles of the property derivatives market, ad- vantages and disadvantages and the market users. In chapter three the basic property derivative instruments (property swaps, property forwards, property fu- tures and property options) are presented. Afterwards the underlying indices are explained in chapter four. First the characteristics of indices are mentioned, se- cond the important international indices are outlined and third the indices in Austria are discussed. Chapter five deals with various pricing models of property deriva- tives. In spite of a comprehensive literature research it was not possible to find the leading pricing model. Thus, this chapter gives a short overview of different pricing models and tries to find some influencing factors. In chapter six, the Austrian property derivatives market and the Austrian property market are explained and compared with the UK market and the valuation of a property swap on the UK All Property index is explained in detail. Chapter seven summarizes the important obstacles in developing a property derivatives market and mentions further research topics for a possible development in Austria.
For this paper an appendix with continuative information is available. The references to the appendix are included in the chapters.
The terms “property” and “real estate” are used as a synonym in this paper. By using the terms “physical property” and “physical real estate” the author always means physical available buildings.
Just to avoid misunderstandings the notation of numbers is done in the Englishstyle, so the English billion is the equivalent of the German “Milliarde”.
Chapter two deals with the principles of the property derivatives market, with its historical source and its development. Advantages and Disadvantages are explained in the following. Finally an overview about the market participants and its share of the market volume are shown.
As already stated in chapter 1, three fundamental requirements have to be fulfilled: sufficient large market size, need to invest or hedge and risk in sense of volatile returns and credible index. This chapter will outline the first two fundamental requirements, the index will be explained in chapter 4.
In general, a market is liquid if large volumes can be traded at anytime while not affecting market prices. In the real estate market, turnover is much lower than for most security markets, compared to the market size of physical properties, its liquidity is low.6 Figure 2 shows that in 2006 the turnover of physical properties was about one-tenth compared to the turnover of stocks in the US.
Abbildung in dieser Leseprobe nicht enthalten
Figure 2: Monthly annualized turnover rates of single family properties versus turnover rates of stocks in the US7
The first implementation in 1991 of a property derivative in the UK failed, but the UK market started to keep pushing up and now sets the standard not only in Eu- rope, but also in the world. In the UK the property derivatives market on the In- vestment Property Databank index (see chapter 4.2.) rose rapidly.8 At the begin- ning of 2007 the total volume of property derivatives was GBP 7.6 billion ( EUR 8.8 billion)9 which was six times more than at the end of 2005 (see figure 3).10
Abbildung in dieser Leseprobe nicht enthalten
Figure 3: Property derivatives based on the IPD index (GBP billion)11
Irrespective to the fact of exponential growth, it is necessary to mention some con- straints that are inherent in these figures. First there is the possibility of multiple counting, because one transaction can result in several interbank transactions, which are all reported to the IPD. Second, the IPD only considers reported trans- actions. It is assumed that not all transactions are reported, thereof some are missing in the index, thus showing an incomplete overview of the market.12
Derivatives enable a faster, cheaper and more effective execution of allocation strategies, short-term hedges, risk transfer and geographical diversification compared to direct investments.13 For the first time it is possible to get passive property exposure (i.e. property Beta) for the asset class of real estates and use the advantage of missing idiosyncratic risk, i.e. the advantage of getting a very well diversified exposure while being cost efficient.14
There are hardly any physical transactions without a due diligence process which takes several months up to more than a year until the deal is closed. Derivatives enable a very quick transaction and due to their flexibility15 they allow an appropriate reaction to changing market conditions.
In general, the higher the liquidity is in a specific derivative instrument, the greater is the ability to trade it at lower costs.16 Transaction costs for physical investments including taxes, lawyer fees, due diligence expenses and so on, range between 7% to 14% of the investment volume, depending on the country where someone wants to invest. All in all these costs are much higher than those for property derivatives, which depend on the maturity and range from ~0.5% for a maturity of one year and about ~3.9% for a maturity of ten years.17
Derivative trading is possible in any size, so you do not have to find a suitable physical property to invest the amount of money which is intended for investing.18
Investing in a property index certificate gives exposure to a broadly diversified portfolio, which constitutes the index. Depending on the kind of index, a lot of properties with a huge value are reflected through this index. Such diversification would be impossible to achieve from investing in physical properties.19
Returns created by investors can in general be separated into Alpha-returns and Beta-returns, whereby Beta represents the projected market returns, for example those of an index.20 It is a measure of the systematic risk of an asset which cannot be diversified away.21 In contrast Alpha-risks can be diversified away.22 Alpha- returns represent the amount by which an investor is able to outperform the index returns through above average management performance on the underlying prop- erty.23 If, for example, an owner of residential properties believes that the residen- tial market will soon be bearish24 for a while and that this properties still will be able to outperform the market due to the superior management skills, he then could hedge his market risk by selling Beta (going short on the index) in return for a fixed interest rate and still earn Alpha through successful asset management.25
Short selling derivatives or selling a financial instrument of which the underlying assets are not owned by the seller is possible. This technique is used by investors who try to profit from market depreciations when they expect a real estate market to decline.26 This is not possible with directly held properties.
A portfolio manager can use property derivatives to change revenues of their physical assets, for example retail real estates, against the performance of an office index, if a declining retail market is expected. The calculation of the retail revenues is based on a retail index, the revenues are changed against the office revenues, which are based on an office index.27
An outcome of liquid established derivative markets is the improvement of market information which results in better transparency and finally contributes to more efficiency in the real estate market.28 This advantage is beneficial for all market participants, not only for the property derivative business.
The disadvantages and risks of property derivatives are mainly the same as for other financial assets. They have credit, legal, market, operational, systematic and settlement risk. Most attention is paid to credit risk (also called liquidity risk), which occurs when the trading partner does not fulfill its obligations and effects the continuity and profitability of financial institutions and institutional investors.29 For further information about the mentioned risks see appendix 2.
A lot of disadvantages are related to the fact that property derivatives are still a new market, where only certain regional and sectoral investments are presentable due to the actual illiquidity and the lack of know-how which exist as temporal dis- advantages.
A major risk in any investment with derivatives is that the chosen index is composed by properties that do not reflect the portfolio that the investor wants to hedge. It is absolutely necessary that end users who want to hedge their risk very careful find an index which correlates with their portfolio.30 Also the credibility of the underlying index has to be ensured.31,32
For some investors who are allowed to hold only a maximum share of liquidity, a property derivative is only a limited use because they do not count as real estate holding.33
For further comparison with other real estate investments (direct property investments, open property funds, closed property funds, special funds, G-REITs and Property Derivatives) see appendix 3.
Currently there is no official data on the proportion of trading volumes by user types, but it is estimated that approximately 40% of market volume is inter-bank trading with the main purpose of proprietary trading and realization of hedging strategies. The second largest market participants are pension funds who have the purpose of tactical asset allocation, strategic long-term asset allocation and prop- erty sub-sector allocation. The last two scopes are the most frequent ones. Other market participants are insurance funds, property funds, hedge funds, property companies and private persons. As it is with other Overt-the-Counter derivative markets, it is expected that the proportion of volume taken by banks will grow as the market itself grows.34
[...]
1 Syz (2008) p.3.
2 see: Osipova (2004) p.4.
3 see: Syz (2008) p.23.
4 see: Fabozzi / Shiller / Tunaru (2009a) p.8.
5 Own Figure (2010).
6 see: Syz (2008) p.23.
7 see: Syz (2008) p.4.
8 see: Andersen / Schneider (2008) p.401.
9 Assumed exchange rate EUR 1.1609 GBP 1
10 see: Just / Feil (2007) p.1.
11 see: Just / Feil (2007) p.1.
12 see: Just / Feil (2007) p.8.
13 see: Syz (2008) p.27.
14 see: Syz (2008) p.162.
15 see: Syz (2008) p.24.
16 see: Van Hasselt (2003) p.38.
17 see: Karg (2009) p.16.
18 see: Thomas (2008) p.389.
19 see: Thomas (2008) p.389.
20 see: Andersen / Schneider (2008) p.399.
21 see: Hull (2009) p.774, p.790.
22 see: Hull (2009) p.786.
23 see: Andersen / Schneider (2008) p.399.
24 A bearish market describes a period in which investment prices fall, accompanied by widespread pessimism.
25 see: Andersen / Schneider (2008) p.399.
26 see: Van Hasselt (2003) p.38.
27 see: Knobloch (2007) p.10.
28 see: Syz (2008) p.24.
29 see: Van Hasselt (2003) p.39.
30 see: Andersen / Schneider (2008) p.400.
31 see: Syz (2008) p.24.
32 see: Höchtl (2010) question 4.
33 see: Piazolo (2008) p.369.
34 see: Investment Property Forum (2010b) p.6-7.
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