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Real estate derivatives next for Singapore?

Despite their complexity, ONG CHOON FAH points out the distinct advantages this financial product can offer

THE management of risks is central to all investments, including real estate.

The financial markets have, since the 1970s, managed risks in the form of derivatives – financial instruments where the return is based on the return of another underlying asset eg, equity or bond. Often used by sophisticated investors such as investment banks and hedge funds, derivatives have a chequered history.

While some view them as a form of speculation, others view them as a way of hedging risk exposure.

With increasing sophistication and integration of the financial and real estate markets, underpinned by the globalisation of real estate investments, property derivatives are now available in many markets, including the UK, US, Germany, France, Australia, Japan and Hong Kong. Real estate derivatives usually have tenures of between one and five years and operate similarly as trades on the stock exchange.

Typically, one party bets that the total returns from the real estate, which includes rental income and capital appreciation, will exceed a stipulated figure while the other bets it will not. Like all derivatives, real estate derivatives serve some very important functions:

  • They provide valuable information on the underlying real estate assets on which futures contracts are based and in so doing, facilitate price discovery which is currently lacking due to the absence of a central exchange for real estate. Pricing of real estate derivatives also indicates prospects of the real estate market

  • They facilitate risk management through hedging, especially given the illiquid nature of real estate. Portfolio managers will then have the flexibility in terms of asset allocation and moving from one real estate market to another

  • They lower transaction costs, reduce lead time and hence increase market efficiency.

    In addition, investors can get market exposure without issues relating to owning the physical real estate eg, management.

    In the case of a Property Total Return Swap (PTRS), it enables real estate owners to sell their exposure in the real estate market without disposing the physical assets.

    Unlike in the sale of real estate, where the vendor will need to build up his portfolio of assets all over again, in the case of PTRS, the vendor returns to his original market position upon maturity. Another advantage of PTRS is that it is liquid and can be traded in the secondary market before maturity.

There are many other forms of real estate derivatives. In a cash-backed contract, a single payment at the commencement of the contract is swapped for future payments in line with the performance of the underlying real estate asset. In other arrangements, cash flows are swapped periodically with payments, either pre-determined or dependent on the performance of the underlying real estate.

In the case of Property Index Forwards, it allows investors to gain exposure to the real estate market, without investing in the physical assets, where the return is equivalent to the capital performance of the real estate asset with consideration paid either at the start or upon maturity.

Yet another form is the Property Index Certificate (PIC), a total return instrument where payment is pegged to the rental income and capital return equivalent to the capital performance of an agreed real estate index. As the index reflects the appraisal of the underlying real estate asset, consideration payable for a PIC is equivalent to the level of the index at the time.

Being a financial instrument, there is no real estate agency fees payable with significantly lower legal costs and stamp duty compared with real estate transactions. The purchase price is also established at the onset, removing price uncertainty which is often clouded in a physical real estate transaction. With a fixed term contract, parties involved can establish an exit strategy based on the real estate index upon maturity.

In the UK, where real estate derivatives debut, derivatives for commercial properties are based on the All Property Annual Index by Investment Property Databank Ltd (IPD) which is widely accepted as an independent and good measure of real estate performance. The IPD represents over 40 per cent of the commercial market in the UK.

Derivatives remain highly controversial as they are complicated and potentially less transparent.

Being complex financial instruments, there is a need to understand them well in order to use them effectively and responsibly, to manage risks. They allow investors exposure to a particular real estate market without acquiring the underlying physical asset. They can also be traded in smaller denominations and allows retail investors an additional investment instrument.

Growth of the real estate derivative markets in the UK and US have been driven mainly by institutional investors as they increase their asset allocation to real estate. Real estate swaps are also being established for sub-sectors of the market, together with capital-only and income-only swaps.

In Asia, the first real estate derivative was created in early 2007 between ABN Amro and Sun Hung Kai Financial based on a residential index – The University of Hong Kong’s Hong Kong Island Residential Price Index Series (HKU-HRPI). In the arrangement, ABN Amro gets exposure to the Hong Kong residential property market through receiving the change in the residential price index from Sung Hung Kai Financial. In turn, Sung Hung Kai Financial receives a payment based on an interest spread fixed on HIBOR. In so doing, ABN Amro is effectively buying an exposure in the Hong Kong residential market with Sun Hug Kai Financial virtually (as opposed to directly) selling the property.

The Reit market in Singapore has developed successfully since its debut in 2001. Today, there are 17 Reits listed on the Singapore Exchange, comprising both real estate assets in Singapore and the region.

For the next lap, it is timely that Singapore develops a real estate derivative market. This will further grow and enhance its role as a financial hub.

However, infrastructure must be developed in terms of industry standards for appraising the real estate assets, regulations and trading platforms.

Critical to this is the need for a robust and widely accepted real estate index/sub-indices on which to base the trade.

These indices will need to be published as regular as on a monthly basis to underpin secondary market trades.

There is also a need for real estate forecasting capabilities to facilitate the market. As it is, various market participants are exploring the development of a real estate derivative market in Singapore and it is a matter of time before these instruments make their way to main street.


Source: Business Times 27 Sept 07

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