Derivatives: Pricing points to only a short-lived property market rally

The derivatives market has already priced in the physical market’s rally and suggests capital value growth will slow down

CBRE-GFI market commentary

The derivative curve’s steady front end and falling back end reflect concern about UK property’s long-term growth prospects, writes Michel Heller. Derivative prices suggest that the physical market’s rally has been fully-priced in and will be short-lived at best.

The IPD UK Monthly Index for January showed commercial property up 0.98%, compared with 2.4% in November and 3% in December (the largest ever monthly growth in IPD’s history). Capital growth eased to 1% in January but City and West End offices returned to rental growth, of 0.2% and 0.3% respectively. At the All-Property level, rental growth decline eased to -0.2% – the shallowest fall since Lehman Brothers’ collapse.

All- Property initial yields are now 7%, according to IPD. January’s value slowdown is the first evidence of capital values entering a period of moderation. But certain sub-sectors, such as central London offices, still show strong capital growth.

Figures from The Association of Real Estate Funds show institutional investors committed their biggest ever amount to UK commercial property in Q4 2009. Unlisted pooled funds attracted £2.9bn on a net basis, up from £400m in Q3, while institutional property funds raised more than £3.2bn; in the physical market, demand clearly outweighs supply, suggesting an expectation of further capital value growth.

But some expect this equilibrium to ease this year as opportunistic sellers cash in and banks release more assets after the election. Derivatives are priced off the Annual Index and the 2009 figure is not due until the end of February, so the market has still been trading the year 2009.

The Estimate of Annual Index returned 0.37% for 2009, the IPD Monthly Index 2.18% and the Quarterly Index 3.4%. The derivatives market is pricing in a 2.5% total return, an increase of 75bps on the month.

Pricing for 2010 has been in a tight 9%-11% range since November, but rose 25bps over January, implying a 9.75% total return. Assuming a 7% income return, this would result in the first UK property value gain for four years, at 2.75%.

Following an 8.8% capital bounce from the July 2009 low point to December 2009, the market expects a further modest capital return for 2010, falling into negative territory until after 2014. The market is pricing in 6.8% annual total returns for 2011- 2014; a 70bps annual fall.

Overall, the curve implies a 4.2% capital fall between December 2009 and December 2014, with no sustained recovery until after 2014. The derivatives market is still concerned about the high volumes of debt that need refinancing after 2010, and their effect on property prices and possible interest rates rises.

Investors are buying derivatives as the cheapest way to gain property exposure while REITs and secondary units trade at premiums to net asset values. But similarly, some derivatives buyers believe the market (or certain sectors) has over-shot, and there is a greater risk of a double-dip recession than was previously thought. This means we are also seeing more net sellers of secondary units.

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