"Some of the U.K.'s largest investment institutions are planning to launch a property derivatives market in an attempt to put commercial property on an equal footing with other financial assets." At least, that was reported as long ago as February 1996 by the Financial Times...and not much happened in the aftermath. A 1991 attempt by the London Futures and Options Exchange to create an exchange-traded futures contract similarly foundered when it was revealed market insiders had artificially supported trading volumes.
Securitized instruments linked to both commercial and residential property price indices have fared better over the years. Consider, respectively, Barclays Capital's ongoing issuance of commercial property index certificates and the numerous retail property-linked investments on offer from the major U.K. building societies. But to date there has been little or no 'pure' over-the-counter activity.
All that may finally be about to change, if recent events are anything to go by. There is ample evidence of completed deals, press coverage is high, property derivative desks and interest groups are springing up around the City and the conference circuit is waking up to the potential. Add in related and favorable developments in the tax, legal and regulatory arenas, a better understanding of and appetite for derivatives among the end user and investor community in general, as well as acceptance of the Investment Property Databank index as a credible and robust commercial property pricing source and the virtuous circle is all but complete.
This article considers the key structural, commercial, legal and documentation issues that arise in relation to OTC property derivatives, using a recently concluded IPD index-based transaction, on which the author advised, as a case study.
Case Study
The buyer, or synthetic investor, was the trustee of a FTSE-listed company pension fund and a frequent investor in U.K. commercial property. It had, however, never bought commercial property by synthetic means and was largely unfamiliar with International Swaps and Derivatives Association documentation. It was attracted to the derivative by a number of factors:
* Relatively assured and comparatively favourable tax treatment (e.g. avoidance of stamp duty land tax that a physical investment would have attracted);
* Relative speed of execution;
* Uncontroversial accounting treatment;
* Belief that the transaction was within its powers as trustee (i.e. no necessity to change its constitution merely to accommodate the derivative);
* No requirement to undertake property-related legal and commercial due diligence;
* Reduced professional fees (e.g. legal fees of less than a third of those in relation to a comparable physical investment);
* Relative ease of exit, with quarterly early termination rights in its favour; and
* Confidence in the index.
The seller, or synthetic divestor, was an international investment bank with a nascent property derivatives operation. Its dual concerns were to part-hedge a larger position it was concurrently negotiating with a third party and to be seen to be book building.
The transaction term was three years, against a sizeable notional. Index appreciation/depreciation (adjusted, for reasons considered later) was to be payable annually, with LIBOR plus a spread representing the buyer's synthetic funding costs to be payable quarterly against a synthetic fixed yield. This is directly analogous, in fact, to an equity index swap structured to pay synthetic dividends.
Key Structural And Commercial Issues
The choice of IPD as index provider was uncontroversial, as was the choice of its U.K. All Property Annual Total Return sub-index, since it was that sub-index which was the underlying on the seller's back-to-back contract. While the existence of the back-to-back was helpful in certain respects, the seller's desire to zero out basis risk between it and the contract with the buyer complicated negotiations. In the end, the seller was compelled, both in order to get the trade done and to meet the legitimate demands of the buyer for a customized contract, to accept a modest but not insignificant degree of economic asymmetry.
The credit spread on the synthetic funding leg of the transaction was similarly not an issue and matters were simplified by both parties foregoing a requirement for collateral. This avoided thorny technical questions such as how and how often to mark-to-market, for collateral posting purposes, a contract in relation to which the index level would be published only infrequently--at best monthly, with annualized monthly statistics themselves displaying a slight variance to the actual annual index level.
The synthetic yield was a curious feature. Economically, it served no purpose since it was neutralized through a corresponding downward/upward adjustment to the index appreciation/depreciation calculation and existed merely to satisfy the buyer's desire to be able to demonstrate, optically, a return on its investment. Greater end user familiarity with the product may, over time, mean that such artificialities can be dispensed with.
The notional was expressed to remain static over the life of the contract, equating to a constant investment, but could equally have been subject to periodic reset, which would equate to a rebalancing in respect of realized profits/losses. This again is reminiscent of considerations that arise in relation to standard equity derivative transactions.
Finally, the timing of index level determinations as well as actual payment dates under the contract were each structured for maximum consistency with IPD data collation, validation and publication methodologies and for optimal net settlement.
Key Legal And Documentation Issues
A key legal issue for both parties was the buyer's capacity to contract. Pension funds, as well as UCITs and similar investment vehicles, are subject to a myriad of statutory, regulatory and internal limitations on what they can and cannot do. In the face of the buyer's reluctance to amend its constitution and a marginally uncertain legal position, the seller was forced to take a pragmatic view. It is worth mentioning in passing that U.K. building societies are precluded by statute from entering into property derivative transactions unless the underlying is a residential property price index.
A further critical issue was tax treatment. The buyer's status was such that it fell outside of the new property derivatives tax legislation, updated August 2004, and as a result was compelled to seek assurances from the U.K. tax authorities that gains or losses on the contract would, as it had hoped, be exempt from income tax.
A less demanding issue was the buyer's insistence on seeing evidence of the sellers' authorization to make reference (in the contract) to the index, which is trademarked by IPD.
Documentation took the form of an ISDA Master Agreement, related schedule and a long-form confirmation, the latter taking its inspiration from standard ISDA equity index derivative templates. Matters dealt with by the documentation suite included:
* Pension fund-specific tax and other representations, events of default and document delivery obligations;
* LIBOR screen page failure;
* Delayed or manifest error in publication of the index;
* Discontinuance/rebasing/material change to the composition of the index; and
* Disappearance of IPD/appointment of a successor sponsor.
Contract negotiations took five to six weeks to conclude, neither the buyer nor the seller being willing to trade on a pre-Master basis.
Will The Trend Last?
Much in the same way appetite for weather derivatives and other such instruments has ebbed and flowed over recent years, property derivatives could be just a phase. On the other hand, there are real grounds for optimism, in relation to which gently educating the end user base and remaining sensitive and flexible to its needs are perhaps priorities. It may then not be too far-fetched to imagine the current index-based market both growing and transforming itself over time into one where pure property price risk in customized property baskets, individual properties and even floors of individual properties is traded as freely as is, say, single-name default risk under a credit derivative.
This week's Learning Curve was written by Gary Walker, partner in the derivatives group at City law firm Field Fisher Waterhouse.
