Derivatives: Pricing points to a stabilised market on long road to recovery

Derivatives contracts are pricing in a 5% total capital fall for 2009, while long-term pricing reflects fears of a slow recovery.

CBRE-GFI market commentary

As the physical market continues its rally, property derivatives have been remarkably stable over the past month, writes Michel Heller

This highlights the fact that derivatives tend to price in expected moves in the underlying physical market long before we see them happening. The IPD UK Monthly Index for December, published on 15 January, showed commercial property up 3.0%, compared with 2.4% in November – the largest monthly growth in IPD’s 23-year history.

The December All-Property total return was 3.6%, bringing 2009 annual total returns to 2.2%. Capital growth for the year was -5.6%. December’s rental value growth was slightly weaker than November’s -0.3% at -0.4%.

At a sector level, offices recorded an 8.4% capital value fall for 2009, the industrial sector ended the year 4.5% lower and retail 4.3% lower. December was the sixth consecutive month of yield compression and average initial yields ended the month at 7.03%, compared with 7.3% in November.

This did not affect derivatives pricing, as IPD was in line with market expectations after the release of the CBRE December Monthly Index a week earlier, showing 3.3% capital growth and a 3.9% All-Property return. But it is interesting to note the disparity between the Estimate of Annual Index, which recorded 0.37% growth for 2009, and the 2.2% figure on the IPD Monthly Index. The Estimate of Annual uses monthly valuation figures, but reweighted to accord with the IPD Annual Index.

The derivatives market is now pricing in total returns of 1.75% for 2009. Contracts for 2009 will trade until the release of the Annual Index in February 2010, but trading is likely to be limited to the 0.4%-2.2% range.

The current 1.75% market price prices in around 5% capital falls; the third annual capital fall for UK commercial property. Over the past month, 2010 contract pricing has been in a very tight range, with support at 9% but resistance at 10%.

a current 9.5% total return – assuming an income of 7% – the market is pricing in its first capital gain in four years, at 2.5%. With big premiums being paid in the indirect market, this is arguably cheap, but the derivatives market is concerned about potential interest rate rises, especially after an election, and the need for refinancing burning a hole in the equity available to support the asset class.

For 2011-2014 inclusive, the market is pricing in 7.5% total returns per annum. Depending on your view of income this equates to a flat curve, or, at best, minute capital gains for these years, resulting in a long commercial property fall and no recovery to peak 2007 levels until well after 2014.

The market is clearly not convinced that a property rally is sustainable, with prime concerns focusing on interest rate movements and the sheer weight of property refinancing that will be required after 2010. These fears are not being borne out in the indirect market, where funds are trading at premiums to December 2009 net asset value