Derivatives: Derivatives still pricing in short-term gains but long-term losses

Contracts for 2009 have continued to rally, but modest capital falls are expected in the 2011-2014 period

CBRE-GFI market commentary

For the third consecutive month, the derivatives market has priced in gains at the front end of the curve but negative sentiment after 2010, writes Michel Heller. The November IPD UK Monthly Index revealed that commercial property values rose by 2.4% (compared with 1.86% in October) – the largest monthly increase in 15 years, bringing the compound growth since August to 5.4%.

Capital growth for the year to date stands at -8.4%, while steady income returns have helped the total return for the  11 months to recover to -1.4%. The All-Property total return for the month came in at 3%. Rental growth has fallen from the deepest monthly negative figure of -1.3% in March this year to -0.3% in November. November was also the fifth consecutive month of yield compression, with average initial yields ending the month at 7.3%, compared with 7.48% at the end of October.

Sector wise, capital growth was highest in retail, at 2.8%, followed by industrial, at 2.1% and then offices, at 1.8%. The IPD Estimate of Annual total return was 2.86% for the month, or a -3.07% total return for the year to date.

It is worth remembering that property derivatives are traded on the IPD Annual Index, and in volatile times – such as the past two years – the Annual Index and the Estimate of Annual Index are not always in line with one another. This is primarily because the weightings of the index changes dramatically over the course of the year, as do the quality of the assets that are being valued on a monthly versus an annual basis, and  the time between annual and monthly valuations being concluded.

As such, the current derivatives mid price of 1.5% total returns for 2009 is not necessarily saying that the market is expecting a 4.5% total return gain in December, as the market would be pricing in the disparity between the two indices as well. This equates to a continued rally over the past month for 2009 contracts, which have gained 1.2%. This still equates to a capital value fall, but is significantly better than the -21% fall that was being priced in at the start of the year.

The 2010 contracts, which have been trading in a tight range of 8%-11% since August, have been in a tighter range of 9.75%-10.75% over the past month. The market is pricing in a 10% total return for the year, which would equate to a modest capital rise for the year – the first since 2006.

However, after 2010 the market expects values to fall  again, with modest capital falls for 2011-2014 inclusive. The curve is pricing in an average annual total return  of 7.3% per year, up 30 basis points per year from this time last month.

Income expectations for this period average 8.4%, implying capital loses of 4.4% for the period; such a fall would not take us back to the lows of the trough earlier this year, but do suggest that substantial growth will not return until after 2014.

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