Mature property derivatives market needed

European real estate investors have never needed a mature property derivatives market more than they do now. But they have also never been more wary of how synthetic trades can push them into the eye of the financial market storm.

The buying and selling of actual buildings has virtually ground to a halt. Property shares are reflecting this and while investors would normally turn to the derivatives market in times like these to adjust their portfolios, bank collapses and fears of counterparty risk have also choked off this avenue.

Fund managers, property firms and real estate lenders are mulling this quandary right across Europe, where the ability to transact bricks and mortar has plummeted, leaving many unable to stem losses on freefalling property investments.

Property derivatives offer an alternative to physical asset sales but banking sector cannibalisation and a major reappraisal of counterparty risk have pounded investor confidence.

Until this returns, growth in this infant market could be stunted, market experts say.

"Cast your mind back 14 months ago, if you were trading with a financial institution, you would have very few concerns about its credit rating but recent events have taught us to expect the unexpected," said Alessandro Bronda, head of investment strategy at Aberdeen Property Investors.

"You could argue that a property derivative is no longer a pure form of property investment, because you are also making a bet on the credit quality and riskiness of your counterparty. If they don't survive ... then you're in trouble," Mr Bronda said.

Europe's nascent property derivatives market offers over-the-counter trading mainly in swaps based on the total return on Investment Property Databank's UK All Property index for fixed periods, in exchange for fixed interest payments.

Investors use swaps to adjust exposure to property in a cheaper and more efficient way than buying or selling buildings.

Other countries such as France, Germany, the US, Spain and Japan have seen a small number of trades but the market is yet to capture significant interest outside Britain.

IPD data shows the total notional value of all UK, French and German property derivative trades grew to €23.6 billion between 2004 and June 2008.

This is still tiny compared with other derivative markets such as credit derivatives, where the notional amount outstanding in the first half of this yearwas €41 trillion, International Swaps and Derivatives Association data shows.

But with physical property transactions shrinking as access to debt funding has dwindled, the rationale of a market that enables investors to gain or hedge exposure to property artificially has probably never been greater.

Data from consultant Jones Lang LaSalle shows physical European property transactions slumped 38 per cent year-on-year to €77 billion in the first half of this year.

Seasoned derivatives investors said they had hoped to use swaps to offset these thin trading volumes but concerns over liquidity and index quality halted some in their tracks.

"The international derivatives scene is a little problematic for us because we are very fastidious about being able to mark these things to market," said Paul McNamara, head of research at PRUPIM, the real estate arm of insurer Prudential.

"If you only have an index that is published once a year, that makes things difficult," he said.

The lack of trades in individual real estate segments such as offices or retail has also prevented many specialist property fund managers from joining the market, Mr McNamara said.

Some prospective derivatives investors may be recoiling from the market as fears over counterparty failures swirl but not everyone believes the sector is in terminal decline.