Property derivatives growing, but pricing still difficult

Presenting at the first quarterly IPF breakfast meeting this morning, Ian Cullen, the forum's head of systems and information standards, reported that the UK property derivatives market had reached a total accumulated notional value of £1.95 billion by the end of June this year, with 157 deals completed, according to an IPF survey.

But Cullen warned: "We can be confident that these numbers are wrong. In the early days we were tracking simple matched trades and it was easy to determine the total size - now it is rather more difficult." The total value could be over £2 billion by the end of the year, he said.

Average deal size has fallen to £12.4 million from £24 million over the past 18 months, but Cullen said: "I anticipate this will rise again after June - we have already seen some deals in the £100 million price range."

Meanwhile, sectoral deals continued to grow, up from total notional of £60 million in Q3 2005 – the first period that IPF measured sectoral statistics – to £90 million in Q2 2006.

A survey of 75 end-users at the meeting revealed sharply higher levels of comfort with commercial property derivatives than with products based on industrial or retail property. The survey took pricing averages from three major brokers and asked participants whether they would buy, sell or remain neutral. The forum's members were generally keen to buy and sell products based on City and West End offices, despite higher margins, but were largely neutral on industrial and retail property.

Another section of the survey found that 38% considered themselves "ready to trade" and 60% would be trading within the next six months.

A review of property derivatives pricing, meanwhile, suggested that margins were too high due to flaws in the market. Professors Andrew Baum, Colin Lizieri and Gianluca Marcato from Reading University Business School predicted that an efficient market should converge on margins of around 100bp, to allow for transaction costs and commissions. The higher margins at present were due to a lack of mandates limiting activity combined with high lot sizes and transaction costs. They believe margins will fall on all tenors in the long term.

But Paul Robinson, an executive director in property company CBRE's capital markets division, argued that management costs, liquidity risk and commissions meant that convergence should be around 200bp instead.

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