Andrew Baum and David Hartzell, Global Property Investment, 2011 Property derivatives – case Hedging development risk

Andrew Baum and David Hartzell, Global Property Investment, 2011 Case – hedging development risk It is late in HotCo, a property development company, is developing a project with total estimated costs of £120m. The project involves the construction of a 100,000 sq ft London West End office building. On completion, the developer will sell the completed development at market value. Completion and sale is planned for late The initial development appraisal envisaged an average letting value of £85/sq ft and a resale capitalisation rate of 6.25%. On this basis, the scheme had an anticipated development value of £136m (100,000 * £85 / 6.25%).

Andrew Baum and David Hartzell, Global Property Investment, 2011 Case - hedging development risk The average letting value at late 2006 had already reached £80psf. The market was strong, and the estimated capitalisation rate for the scheme at that point had fallen to 5%. The development value at the point was £160m (100,000 * £80 / 5%). However, due to commodity price inflation estimated costs had risen to £130m. Nonetheless, the strong market meant that at that point the scheme remained profitable. At the end of 2006, market returns had been strong, but the development company felt that a downturn was a strong probability.

Andrew Baum and David Hartzell, Global Property Investment, 2011 Case: consensus scenarios Market scenario Prob Stronger20% 30% Strong10% 40% Weak0% 30% The 2 year IPD swap price was 10% in December 2006

Andrew Baum and David Hartzell, Global Property Investment, 2011 Case – action? The price of buying a two year IPD total return swap at December 2006 was 10%. What action could the board take in late 2006 to manage its risk? The price of buying a two year IPD total return swap at December 2006 was 10%. Assume the developer sells IPD exposure for this price. Its exposure to date is £ 130m, so it could go short £ 130m.

Andrew Baum and David Hartzell, Global Property Investment, 2011 Out-turn – if the market strengthens In December 2007 (or early in the following year) HotCo will receive 10% on £130m = £13m in payment of the fixed leg. It will pay out the IPD total return for 2007 of 20% on £130m, or £26m. Net swap loss for 2007 is £13m. The 2008 out-turn is a 20% return on IPD. In December 2008 HotCo receives £13m for the fixed leg and pays the IPD total return of 20% on £130m = £26m, producing a net loss of £13m.

Andrew Baum and David Hartzell, Global Property Investment, 2011 Out-turn – if the market strengthens The completion value of the scheme in a strong market is high at £170m, with capitalisation rates down to 5% and rents firm at £85. (100,000 * £85 / 5% = £170m.) HotCo’s net position is a profit on the project of £40m, plus a swap loss of £26m. This creates a profit of £14m compared to a do-nothing (no swap) profit of £40m.

Andrew Baum and David Hartzell, Global Property Investment, 2011 Out-turn – if the market remains strong In December 2007 HotCo will receive 10% on £130m = £13m in payment of the fixed leg. It will pay out the IPD total return for 2007 of 10% on £130m, or £13m. The total gain/loss for 2007 is zero. The 2008 out-turn is a 10% return on IPD. In December 2008 HotCo receives £13m for the fixed leg and pays the IPD total return of 10% on £130m = £13m, producing a net gain/loss for 2008 of zero

Andrew Baum and David Hartzell, Global Property Investment, 2011 Out-turn – if the market remains strong Capitalisation rates have remained low at 5.25% and the rent is again firm at £85/sq ft. The completion value of the scheme is around £162m (100,000 * £85 / 5.25% = £161.9m). HotCo’s net position is a gain on the project of £31.9m, plus a swap loss of zero: this is a net gain of £31.9m compared to the same do-nothing gain.

Andrew Baum and David Hartzell, Global Property Investment, 2011 Out-turn – if the market weakens In December 2007 HotCo will receive 10% on £130m = £13m in payment of the fixed leg. It will pay out the IPD total return for 2007 of zero. The total income for 2007 is £13m. In December 2008 HotCo will receive 10% on £130m = £13m in payment of the fixed leg. The 2008 out-turn is a zero return on IPD. It will pay out the 2008 total return of zero and the total income for 2008 is £13m.

Andrew Baum and David Hartzell, Global Property Investment, 2011 Out-turn – if the market weakens In the now-weak market, capitalisation rates have reverted back to 6.25% and the rent is lower at £80/sq ft. The completion value of the scheme is now £128m (100,000 * £80 / 6.25% = £128m.) The project now makes a loss of £2m. The combined position is a loss on the scheme of £2m plus a swap gain of £26m: a net gain of £24m (compared to a do-nothing loss of £2m).

Andrew Baum and David Hartzell, Global Property Investment, 2011 Case: out-turns Do nothingSwapProb Stronger401430% Strong32 40% Weak(2)2430% Weighted mean24.2

Andrew Baum and David Hartzell, Global Property Investment, 2011 Case: result The swap has a neutral effect on the average and probability-weighted out-turns. A profit is made in all three out-turns, which is not true if no swap is put in place, and the range and standard deviation (risk) of returns is reduced.