Derivatives: Continuing capital growth boosts derivatives pricing

Pricing for 2011 contracts has picked up in the past month following the 22nd consecutive month of capital growth

CBRE-GFI market commentary

Derivatives prices have begun to rally as we near the end of Q2 2011, writes Sam Whitham. This is down to IPD revealing positive, if weak, capital growth for the fifth consecutive month this year. Contracts for 2011 are pricing closer to a level that reflects capital values remaining flat  for the year, and have upside potential as long as monthly capital growth figures avoid negative territory.

May 2011 provided 0.7% All- Property total returns, made up of marginal 0.14% capital growth and 0.55% income return. Year-to-date returns are 3.45% with seven months of the year left. Annual 2011 swap contracts are priced at around 6.15% total return, continuing to imply a 1%-plus capital values fall from now until December. But if current rates of return continued for the rest of the year, the total return would be around 8.5%.

The IPD All-Property Index has now recorded capital growth every month since July 2009. But over the same period, income return has fallen from 0.69% per month to 0.55% – its lowest level since capital values began to recover. This has been reflected in a gradual slide in equivalent yields, from 9%-plus in mid- 2009 to around 7.25% this May.

City offices have driven the market, outperforming the All-Property Index for the past 18 months and returning roughly 10% more capital growth since July 2009. Offices and retail have consistently provided capital growth, while industrial figures have flitted between positive and negative for the past 10 months. Annual 2011 contract pricing rose 16% from 5.3% in mid-May to 6.15% in mid-June, while 2012 contract prices remained flat, at 4.05%, continuing to imply falls in capital values of roughly 2.5%.  Contracts for 2013, 2014 and 2015 all rallied 25 basis points  to a 5.5% total return.

Halifax House Price Index contract prices also rallied along the curve. One-year contracts now forecast a 4.5% fall in the average UK house price this year; with prices already up 0.52% so far this year this implies a 5% fall between May and December.  Two-year contracts forecast further falls before a gradual increase in subsequent years. The rally in prices has led to increased interest from market participants, linked to relatively positive whispers from valuation departments. Pricing in the first five months of the year implied little change in capital values. A more definite direction in market sentiment – positive or negative – could help increase volumes.

The UK equity market fell roughly 4% in the past month because of concerns about when, rather than if, Greece will default, and the repercussions.  On 16 June, Bloomberg published an article titled ‘Europe’s “Lehman moment” looms’, as  the CDS swap market upped Greece’s five-year probability  of default to more than 75%. The fall in the FTSE’s value reiterates the fact that the UK has not pulled clear of the tough times that have hung over recent years. Another economic collapse would undoubtedly have a direct effect on commercial property prices and a significant bearing on property derivatives prices, where such occurrences are not priced in.