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With the property market in crisis, a new type of financial instrument is taking centre stage, write Andrew Petersen and Gordon Peery

The liquidity crisis, credit crunch and evidence of a global consumer recession have created a perfect storm that has severely challenged debt and credit capital markets, increased lending costs and dried up balance sheet mortgage lending. Left in the wake of the thunder and lightning are stranded investors and a myriad of balance sheet woes.

However, it is not all doom and gloom. From the storm has emerged a relatively new derivative instrument that enables investors and portfolio managers to gain immediate exposure to property, or hedge property risk, without actually buying or selling bricks and mortar. Buoyed by a period of record trades, dealers, institutional investors, portfolio managers and other end useras have turned from property to property derivatives.

The growth of derivatives with a property-based underlyer should not be a surprise. After all, property is the largest asset class in the world and the ability of investors to gain immediate, inexpensive exposure to property without traditional transaction costs gives derivatives a significant advantage over other property-related investment products. After their widespread introduction in the UK in 2005, commercial property derivative volumes have reached £3.7bn per annum with accelerating growth. In 2006 there were 360 transactions – five times as many as the previous year. Further, at the start of 2007, the value of property derivatives based on the Investment Property Databank (IPD) Index reached a cumulative notional level of £7.6bn.

A property derivative is an instrument with a price derived from a published property index, referred to as a reference obligation or underlyer. As such, it derives value from an underlying asset or event, with users either passing unwanted risk to a willing counterparty (which assumes that risk for a price) or taking on risk in exchange for a payment.

Over-the-counter property derivatives, which may be used as a synthetic investment or for hedging or leverage purposes, can be tailor-made to fit portfolio needs – thus offering innovative and flexible hedging techniques to portfolio managers and institutional investors holding illiquid property investments. Innovation in this area enables transaction participants to obtain whatever maturity or leverage that is desired. The market and underlying indices are the only boundaries. Instead of incurring the cost of buying and selling physical property, the investor or fund manager may simply purchase a customised product with returns based on an underlying index of real estate values.

Derivatives in the property area thus overcome numerous disadvantages of traditional property investment such as transaction lead time, credit and liquidity market seizures, property management issues, availability and immovability of real property assets and high transaction costs.

There are essentially three levels of documentation in a typical property derivatives trade. At the top is the ISDA Master Agreement, a document with content that never changes. Its dispute resolution and other broad terms apply to every trade unless varied by a Schedule and a Credit Support Annex (CSA). The economics of each trade and other details are evidenced by confirmations contracts with key economic and legal terms that operate under the umbrella of the Master Agreement, as modified by the Schedule and the CSA. These further tailor the transaction to fit the needs and credit profiles of the parties and the derivative product. The most important recent development in the property derivative marketplace is the publication by the International Swaps and Derivatives Association (ISDA) of definitions specifically for property derivative transactions. These definitions enable the parties to efficiently evidence the property derivative trade in shorthand.

Despite the spectacular growth of property derivatives in the UK – and bright signs for continued growth across the globe – certain macro and deal-level risks remain.

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