Derivatives: Long-term doubts linger despite encouraging 2009 return

The IPD UK Annual Index showed a 3.5% property return for 2009, but post-2010 pricing reflects fears that recovery will falter

CBRE-GFI market commentary

The pricing of future property risk has been remarkably stable in recent months, with the derivatives market expecting income return to be the main form of growth in the coming years, writes Michel Heller

The release of the IPD UK Annual Index for 2009, although showing better-than-expected performance, has done little to re-price the risk. The annual index showed a 3.5% total return, or a capital value fall of -3.6% for 2009. Prior to the release of these figures, the derivatives market expected a 2.5% total return for the year.

The lower expectations were the result of earlier figures such as a 0.37% return for 2009 according to the Estimate of Annual Index; the IPD UK Monthly Index posting 2.18%; and the Quarterly Index 3.4%. However, 2009 was the third year of capital falls.

Retail performed best, with a 4.6% total return, followed by industrial, at 4.1%, while offices massively underperformed, with a 0.99% total return. There was huge disparity within subsectors, with retail warehouses returning 4.2% capital growth, compared with -11.3% for shopping centres. Income rose 7.4% for all commercial property, compared with 5.6% in 2008.

Despite the better-than expected IPD pricing, derivatives’ price volatility has been restricted to the front end of the curve. Total returns for 2010 are expected to be 10.6%, an 85bps gain on the month. This year has continued to trade in its tight 9%-11% range, a development that began in November. Assuming a 7.1%  income return, 2010 pricing implies that UK commercial property values will rise for the first time in four years, at 3.5%.

After the 8.8% bounce in capital values from the July 2009 low point to December 2009, the market expects capital values to grow modestly this year, then fall into negative territory again until after 2014. The market is pricing in 6.4% annual total returns for the 2011-2014 period; a fall of 35bps on the month per calendar year.

Overall, the curve implies a 1.2% capital value rise between December 2009 and December 2014, with minor capital value falls expected after 2010. The derivative curve has given a very consistent message so far this year: the market is convinced that yields will fall further in the short term, which is leading to a stronger expected total return for 2010.

However, the market is not convinced that the UK’s economic recovery will be sustainable, because of the uncertainty created by the forthcoming general election and the potential for the Bank of England to take a hawkish stance, at a time when vast levels of CMBS debt needs to be refinanced.

This indicates an interesting dynamic: for those who believe that these risks are being overpriced, the derivatives market is a screaming buy. Investors are buying derivatives as the cheapest way to gain property exposure at a time when REITs and secondary unit trusts are typically trading at premiums to net asset values.

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