Mispricing talk intrigues new property swap players

Estate agent property sales and letting signs are seen in a west London street, February 20, 2004. Talk of mispricing in Britain's fledgling property derivatives sector should give flight to a market whose wings have been clipped by a lack of contrarian views, key market players told Reuters.

LONDON (Reuters) - Talk of mispricing in Britain's fledgling property derivatives sector should give flight to a market whose wings have been clipped by a lack of contrarian views, key market players told Reuters.

Third quarter figures on UK trading volumes due on November 1 are broadly expected to confirm a depressed summer for real estate derivatives traders but debate on how far, and for how long, commercial property values will fall is flourishing -- and helping to draw in vital new investors.

Alex Kinsman and Jamie Goss, directors of the derivatives platform at property services firm Jones Lang LaSalle (JLL.N), said they had identified attractive buying opportunities on long-dated property swaps which they said "undercooked" total property returns in 2010 and 2011.

Current derivative pricing implies a 1.3 percent total property return in 2007, a negative 6.5 percent return in 2008, a return of 6 percent in 2009, 6.5 percent in 2010 and 4.9 percent in 2011.

By contrast, base forecasts from index compiler Investment Property Databank predict total property returns of 2.7 percent in 2007, -2.5 percent in 2008, 9.7 percent in 2009, 7.7 percent in 2010 and 7.9 percent in 2011.

"We think there are genuine buying opportunities on some of the longer-dated swaps where the derivatives market is taking an over-cautious view on where returns will be in the next cycle," said Kinsman.

"Granted it is hard to take a view so far in the future but it is rare to see such an opportunity for investors to buy an index based on such a broad selection of quality assets at those levels," Goss added.

FLAT THIRD QUARTER

Britain's embryonic property derivatives market offers over-the-counter trading in swaps, largely based on the total return on IPD's benchmark UK All Property Indexes over a fixed period in exchange for the London interbank offered rate (LIBOR) plus a spread.

The market enables investors to gain and reduce their exposure to real estate synthetically, without buying or selling any physical assets.

A record 2.9 billion pounds ($5.95 billion) of UK deals were traded in the first quarter but volumes dropped by two-thirds in the three months to end-June, reducing liquidity and deterring new investors.

But Guy Ratcliffe, director of Morgan Stanley's property derivatives operations, said hedge funds had ramped up trading activities and the market was starting to attract fresh blood.

"Q3 has been busy towards the end after a quiet start; and while many traditional players <life funds, pension funds> are still biding their time, we are seeing some new players come into the market," said Ratcliffe.

He said he expected IPD data to show around 2 billion pounds of UK property derivative trades in the third quarter.

Kinsman and Goss were less optimistic, forecasting volumes of less than 1 billion pounds but the pair hoped the pricing shift could lure in a mix of opportunistic buyers and derivative debutants, who tended to favor long-term buying positions.

Nick Scarles, group finance director at Grosvenor, one of the UK's most prolific end-users of property derivatives, told Reuters while the correction in the physical property market had made some investors nervous, others have been waiting to exploit a bout of pessimism.

"A year ago it seemed like everyone was looking to buy long-term exposure to property as returns were so strong, he said. "But we've seen a big swing in pricing in the last few months and this change in the market should start to draw in a different type of buyer," said Scarles.

HEDGING TOOLS

Kinsman said the direct property market cooldown was helping to showcase strategic benefits of using derivatives.

"A downturn in the direct property market typically results in illiquidity which makes it harder for people to adjust their exposure to property -- but this has helped to highlight the usefulness of a derivative product," he said.

Both Goss and Ratcliffe said an increase in the number of parties using property derivatives as hedging instruments was improving the texture of the market whose progress had been hampered by an imbalance between buyers and sellers.

"We're seeing differences of opinion among market participants who say property values are going to fall by 20 percent and those that say values will fall by half that," he said. "Buyers and sellers are taking stronger positions and becoming easier to identify," said Goss.