Property derivatives can mitigate risks.

Posted On Friday, 14 March 2003 02:00 Published by eProp Commercial Property News
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SA investors do not have the option of putting money into instruments derived from underlying assets in the market.

Erwin RodeHow does a risk-averse industrial property investor protect himself when he thinks the industrial property sector may take strain in a specific future period without losing ownership of his property?

And how does a general investor with greater appetite for risk who holds an opposite view bet on his view without acquiring fixed property ownership?

Someone has to create a market where the two kinds of investor can meet to trade their differing risk appetites.

This is the discourse of a property derivatives market which has engulfed SA.

Cortwell Consulting director Jonathan Smith says a derivatives market can prove very useful in fixed property. "It mitigates risk and creates a certain stability for investors," says Smith.

Smith and a number of other property experts agree on the fact that SA has an underdeveloped property derivatives market.

Property economist Erwin Rode says: "I do not know of such a market in SA."

Francois Viruly, another property economist, says that this market is very limited.

Stan Garrun, the MD of the SA branch of global commercial property data bank IPD SA, says he has recently received enquires from people who want to use the Sapix/IPD index to develop property derivatives products.

Property professionals agree in broader terms that the use of derivatives can bring back the lost stature of property as an investment asset class of choice.

While property professionals have spotted the gap, no major moves have been recorded so far.

An initiative by Lyons Financial Solutions has faltered.

The one person who is passionate about a property derivatives market, former Lyons CEO Garry Fromentin, left the group and his initiative collapsed.

Fromentin was looking to launch two property derivative products called index swap and mortgage swap.

With an index swap, an owner of a property can switch to a more diversified portfolio of properties listed on the JSE Securities Exchange SA.

With a mortgage swap, a property owner trades his obligations to service debt attached to the property, thereby protecting himself against interest rate volatility. In return, the property owner pays a market-related notional lease fee to the party assuming the interest rates risk.

The two products address, to a limited extent, the quest of an industrial property investor seeking a time-specific protection against risk.

If the industrial property investor seeks no mistake but a guaranteed income, then swapping his income for a property unit trust's income may not be the best solution because the latter carries a fair amount of volatility and risk.

The ultimate solution is, therefore, a market where the investor can get a guaranteed income agreed to with the risk-taker for a particular duration.

Lease discounting, which is essentially the selling of a building's future cash stream, can to a certain extent fill this gap. In the eyes of many people, lease discounting is a simple financial instrument, but it is actually a derivative. It is an abstract instrument which is derived from an underlying asset (fixed property).

Lease discounting should allow the industrial property investor to secure some amount in relation to a projected future income in the light of uncertainties about the future which she cannot afford to risk.

Local banks do lease discounting on limited occasions.

Smith says there is limited appetite for such deals in the SA market partly because the market is too small and not mature enough to have such deals on a large scale.

"Such deals can only happen in blue chip tenanted buildings," says Smith.

Derivatives get much more complicated than lease discounting and swaps mentioned above.

At their core, derivatives involve futures contracts, forward contracts and options.

The question is how far SA is from housing a property market where investors can trade call or a put options over fixed property.

"A futures market in the SA property sector is very limited," says Smith.

He cites a number of factors causing the limitation. The local property market comes with short term volatility and large cyclical swings, says Smith. He refers to the Johannesburg office market, which has lost a considerable amount of value in the last ten to 12 years.

While that market will increase in value again no-one can predict precisely when and by how much, says Smith.

"In London, prices remain relatively level and can be predicted with relative ease," says Smith.

He says hedging in a market which is linked to volatile interest rates in relatively difficult. Interest rate hedging does take place but value hedging is more difficult, he says.

He says indices are a vital component in a futures market. Although Sapix/IPD is almost there, SA has a limited indexing system in the property market, says Smith.

He says further shortcomings are that property markets are illiquid, have scarce price information and high transaction costs. While derivatives can boost property as commodity a reckless application can be disastrous.

A large number of the types of individuals who invest in fixed property are conservative investors who do not want their money to be confused in the world of financial engineering.

Otherwise they might as well sell their property and buy equities or bonds.

Last modified on Wednesday, 07 May 2014 12:28

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