Andrew Baum and David Hartzell, Global Property Investment, 2011 Property derivatives – an introduction

Andrew Baum and David Hartzell, Global Property Investment, 2011 What are derivatives? ‘ Synthetic exposure’ Forward contracts Futures Options and traded options Swaps Index notes

Andrew Baum and David Hartzell, Global Property Investment, 2011 What are the applications? Speculation – betting on performance Hedging - laying off risk of the ‘underlying’

Andrew Baum and David Hartzell, Global Property Investment, 2011 Swaps An agreement between two parties to exchange two streams of payments for an agreed period of time Interest rate swaps floating for fixed Currency swaps Total return swaps exchange the total returns from assets or markets (such as equity indices) for cash or returns on other assets

Andrew Baum and David Hartzell, Global Property Investment, 2011 Index notes Structured as bonds Income and repayment of capital linked to the performance of an index OTC or listed Sometimes known as structured notes

Andrew Baum and David Hartzell, Global Property Investment, 2011 Property total return swaps Agreements between two parties to exchange payments based on the commercial property market for an agreed period of time Total return swaps – exchanging all property total returns for cash or the returns from other assets or markets – exchanging total returns on some component part of the commercial property market for the returns from some other component part ‘Contracts for difference’

Andrew Baum and David Hartzell, Global Property Investment, 2011 How do swaps work? Crude form – bank acts as broker Investor A Investor B Office sector total returns Retail sector total returns

Andrew Baum and David Hartzell, Global Property Investment, 2011 Mature market form – bank acts as dealer Investor A Bank X Investor B Office sector total returns LIBOR Office sector total returns How do swaps work? Retail sector total returns Retail sector total returns LIBOR Investor C Investor D

Andrew Baum and David Hartzell, Global Property Investment, 2011 Uses of property swaps Multi asset level swaps – swap all-property total returns for other asset classes Property sector swaps – swap market segment returns International index swaps – swap country returns Single property swaps – swap one property for another

Andrew Baum and David Hartzell, Global Property Investment, 2011 Alpha and basis risk Can property investors hedge? Basis risk is the probability that the portfolio will not produce returns in line with the index Long and short positions do not have perfect negative correlation Valuation lag and other technical issues add more risk

Andrew Baum and David Hartzell, Global Property Investment, 2011 Investor A Bank X Investor B Bank X Office sector total returns LIBOR plus margin Retail sector total returns Pricing - what margin?

Andrew Baum and David Hartzell, Global Property Investment, 2011 Return expectations – IPD v LIBOR Simple income approach IPF consensus : c.7.80% LIBOR (interest rate swap, 3 years): c.4.80% Seller of LIBOR should pay margin of 3% less dealer’s fee

Andrew Baum and David Hartzell, Global Property Investment, 2011 Margin versus tenor: theoretical Strong market: buyers Weak market: sellers

Andrew Baum and David Hartzell, Global Property Investment, 2011 Margin versus tenor: Source confidential, actual deals