Deriving RE Gains
Issue 30 - May 07

With the first ever Asian property derivative trade launched in
Hong Kong last month it’s time to investigate property derivatives.

property derivatives
A property derivative is much like any other derivative, it is a transaction based on the value of an underlying asset, in this case the market value of real estate.
The buyer is a party who wants to invest in, or gain exposure to the real estate market. The seller is a party with tangible assets in that market, who wants
to balance or hedge their risk, to protect themselves from any fluctuations in that market. The key factor, for these parties is finding a method to establish the value
of the market and measure how this changes over the duration of their contract. This method is “the index”, the measure of the total value of the market.

According to Muse Kwong, Managing Director, Head of Financial Market Sales, ABN-Amro Hong Kong, “Property derivatives are very simple, they’re very similar to a physical transaction”. ABN-Amro was the buyer, and Sun Hung Kai Financial the vendor, in the first Hong Kong residential property derivative transaction in Asia
in February 2007. Kwong continues, “Party A wants to gain exposure, they will be paying the interest rate (Hibor plus spread) just like that on a mortgage to party B who will be giving him the difference between the property index at maturity and index at the start date, just like the appreciation or depreciation of the property prices. The trade is basically an index swap, buying or selling the index.”

indexing the market
It should be clear by this stage that the most important component of any derivative deal is the index, the measure of market value which will make or
break your derivative. “You need a transparent and credible index”, says Kwong, one which both the buyer and the seller are comfortable trusting with their million, or billion dollar deal. The ideal index establishes and tracks the exact market value of the property concerned in a transaction, but this ideal is impossible to accurately calculate. Instead, the total market value must be estimated and traced using the best data and methodology available.


For the Hong Kong residential property market, data is readily available. Professor K.W Chau, Chair of Real Estate and Construction, University of Hong Kong, says
“We’ve been researching property price indices for quite a long time, we also research on indirect real estate.” For research purposes, his department had long been calculating the total market value of residential property in Hong Kong. When approached to see if this index could be used for property derivative trading, Chau was initially cautious, “I said I need to go back and test it, you use it for academic research it’s one thing, you use it for settle financial derivates it’s another!” He explains that it was not a question of accuracy, but an issue of fitnessfor-
use, “The criteria are different, we cannot use the research index we publish for the purpose of settlement of derivatives, we need to do some modifications.”



However, once Chau and his team had re-examined the robustness of their index, they found that the index was already stable, and with some minimal changes could be used as a basis for financial transactions. Chau believes what is really crucial is that “Everybody is comfortable about the methodology, there’s no such thing as the ideal index, but as long as we tell everybody the rules right at
the very beginning, then they can make the judgement”.

who cares about derivatives?
So, who are the main players in the market, and where is all this money coming from? With property derivative transactions, the buyer and sellers have to be matched. Respected financial journalist Jim Pickard, writing for the Financial Times, remarked that London’s property derivatives market was like “a dysfunctional village market. On one side are three vendors offering radishes,
lamb and cottage cheese when all the buyers want is tomatoes, plaice and Gruyère.” Christiaan van Beek, Broker, Asia Pacific Property Dervatives, GFI Colliers is currently trying to match these buyers and vendors in the Hong Kong market, he says “The only way you can make a market like this is when you listen to everyone”

It’s important that both parties are happy with the index, and the spread. Some
interested parties, explains Van Beek, want an index to match the exact property type and location they want to trade, however, it seems that generally, people are willing to accept this is not possible and work with the available indices as a fair basis for trading. As with all financial markets, the big players are “Investment banks, pension funds, property fund, private wealth mangers and retail banks” says van Beek, basically “anyone wanting to gain exposure on the Hong Kong market”. Even individuals will have a part to play eventually, as a retail sector emerges, van Beek believes. At first “high net worth individuals will get exposure/hedge themselves” using their wealth management services at private banks. But, eventually, “small players with only HK$10,000 will be able to get exposure to, for example, the Hong Kong Island market through some sort of
“tracker fund” or “pool” provided by the retail banks”.

the future for derivatives
In global terms, the UK market is the most active, growing from virtually nothing in
2004 to approximately GBP3.5 bil in 2006. ABN-Amro expects this trend to continue with a total value GBP8 bil estimated by the end of 2007. This growth has been helped by an extremely robust set of indices and sub-indices produced by the Investment Property Databank. There have been small trades in France and, in the U.S, the National Council of Real Estate Investment Fiduciaries (NCREIF) index, which had been under exclusive license to Credit Suisse First Bank, is now freely available.



As for the Asian markets, there are two barriers to the growth of the market. The first is in indexing the markets that people want to invest in. In most Asian
countries, access to the accurate data needed to build a robust index is hampered by low transparency in the market. Due to this fact, the relatively open markets
of Hong Kong and Singapore are likely to see the first actively traded property derivatives. Even with the data available, there is the challenge of building a
commercial index such as the one underpinning the UK market’s growth. Professor Chau is currently working on establishing a commercial index for the Hong Kong, while the National University of Singapore is examining methods for Singapore. The second challenge is the question of liquidity, or whether there are enough buyers and sellers who are prepared to play the market.

“I think this market will take off. I think there is a lot of interest.” says Chau. He believes that, while the market will start with large institutional investors, as liquidity improves there is a market for financial institutions to offer structured produces and eventually, a property derivative product for the man on the street. Kwong agrees with this analysis, highlighting the fact that ABN-AMRO is committed to growing the market, “We are willing to develop the market, the size is not a big factor for considering the trade”. She is hopeful that indices can be set up around Asia, stating “As soon as an index is set up trades can begin.” The more markets available, the better the choices for investors and the more motivation to trade, “I think this should create more demand as people can hedge themselves, gain exposure or rebalance their property exposure around Asia e.g. in different locations like Singapore, Taiwan, China or even around the globe without needing to travel there”. With a glut of new property derivatives seminars springing up on conference schedules across the region, it seems like the market has the potential to form a substantial part of the Real Estate universe. RFP

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