U.K. Real-Estate-Derivatives
Deals Are on the Rise

By Sara Seddon Kilbinger
From The Wall Street Journal Online

The U.K. market for commercial-real-estate derivatives looks poised to expand, opening new windows for investors to take a position in the country's property. The fledgling market also shows signs of spreading elsewhere in Europe, including France, Germany and the Netherlands.

Around £1.25 billion ($2.38 billion) of real-estate derivatives have been traded in the U.K. so far this year, compared with £700 million for all of 2005, according to Ian Cullen, founding director of Investment Property Databank, or IPD, which manages an index to which property derivatives are tied. (Real-estate derivatives are financial contracts that are benchmarked to indexes, such as IPD's.) The market's cumulative value is expected to exceed £2 billion by year's end, said Rawle Parris, executive director of property derivatives at ABN Amro in London.

Last week, London-based real-estate investment company Protego Real Estate Investors said that together with Barclays Capital, the investment-banking subsidiary of Barclays Bank PLC, it has arranged more than £1 billion of trades since the beginning of 2005.

"Derivatives offer a very effective way of getting exposure to U.K. property without having to buy the underlying assets," says Charles Weeks, a principal of Protego. "We have been involved in deals as small as £50,000, so derivatives could also appeal to smaller private investors."

The growth has been driven largely by institutional investors, such as pension funds, which are looking for more property exposure as they allocate more capital to real estate, said Mr. Parris. Other investors, including hedge funds, investment banks and property companies, also are buying property derivatives as the market becomes more transparent, said Mr. Weeks.

Still, the real-estate-derivatives market remains small compared with other real-estate investments. By comparison, issuance of commercial-mortgage-backed securities, or CMBS, in Europe is likely to reach about €58 billion ($74 billion) this year, according to Hans Vrensen, director of securitization research at Barclays Capital in London. And there are risks associated with investing in real-estate derivatives: Their performance is tied to the performance of real-estate assets in the U.K., so any slip in the market will be quickly reflected in lower returns.

A derivatives contract, which usually runs from one to five years, works on a similar principle to trading on a stock exchange. Typically, one party will bet that returns from property will outperform a set benchmark, typically the London interbank offered rate plus a certain percent. The other party will take the opposing view. The payout is based on changes to IPD's index. The IPD U.K. Annual Index had total returns -- capital growth plus income growth -- for all commercial-property sectors of 19.1% last year. Derivatives tied to this index would have reaped similar returns.

So far, 12 banks in the U.K., including Barclays and a unit of New York-based Goldman Sachs Group Inc., have been licensed by IPD to trade property derivatives on IPD indexes. Each bank pays IPD a pro rata royalty payment that depends on the size of the derivative contract negotiated between the counterparties and, in return, IPD makes available the relevant index information.

While the number of real-estate-derivative swaps trades for the U.K. has grown -- 101 in the first half of this year compared with 46 in 2005, according to ABN Amro -- the average deal size fell to £12 million at the end of June from £26 million at the beginning of 2005. The reason: The market has become more liquid, promoting a greater variety of deal sizes, says Mr. Parris. The property-derivatives market in the U.K. gained momentum toward the end of 2004, following clarifications and changes in tax law and solvency rules, which brought property derivatives on a level footing with other derivatives markets, Mr. Parris said.

While the U.K. is home to the only real-estate-derivatives market in Europe, that is expected to change. The Netherlands is considering introducing real-estate derivatives, says Mr. Cullen of IPD. In addition, he says, IPD has talked to banks in France and Germany about licensing them to trade property derivatives tied to IPD's indexes.

In the U.S., the first licensed commercial-property-derivative trades tied to the Chicago-based National Council of Real Estate Investment Fiduciaries Index were completed by Credit Suisse First Boston in February. The NCREIF Index posted total returns of 20.06% for 2005. Credit Suisse has an exclusive agreement with NCREIF to structure commercial-property-derivatives contracts in the U.S., although the agreement will expire in April next year, when NCREIF is expected to offer contracts to additional banks.