Property Derivatives

Insurers that own property, and institutional investors such as pension funds that want property in their portfolios, use these trades when they want to adjust their exposure to property prices without buying or selling buildings.

Swapping a property index for an interest rate

A property derivative is typically a total return swap that exchanges the total return of a property index for an interest rate. The total return is the sum of the return from income such as rent (the income return) and the return from price changes (the capital return). In UK tax rules, a property-based total return swap is defined as a swap of changes in a property index for an interest rate¹. Total return swaps on equities are covered in Equity Swaps and Total Return Swaps.

In the 2007 report of Japan's Real Estate Derivatives Study Group (the 2007 report), most swaps were said to have a term of 3 years².

Consider a hypothetical example in which Company A owns a rental office building worth 10 billion yen. To prepare for a fall in a property index, Company A enters a 3-year swap with a dealer, with a notional of 10 billion yen. Each year, Company A pays the index total return times the notional, and the dealer pays 3% a year times the notional, which is 300 million yen. In a year when the index total return is negative, Company A is the one that receives the index total return times the notional.

Annual payments and the total with the property

The table below follows Company A's swap payments together with the return on the property, year by year. Consider a hypothetical example in which Company A's property has a total return that moves exactly with the index. Amounts are in millions of yen.

In Year 1, when the index rises, Company A is the net payer on the swap, but the return on the property rises by 600 million yen. In Years 2 and 3, when the index falls, the return on the property declines, and Company A receives on the swap instead. Under this assumption, the total is 300 million yen every year and does not depend on the index. In exchange, Company A does not receive the property's price gains when the index rises.

Now consider the case where the dealer trades with an investor who receives the index total return. This investor receives the index total return and pays 3% a year. With the index in the same table, in Year 1 the investor receives 600 million yen and pays 300 million yen, for a net gain of 300 million yen. In Year 2, the investor pays 700 million yen, the index decline of 400 million yen plus the interest of 300 million yen, and in Year 3 pays 1.3 billion yen. The investor earns the same return as a property investment without owning property, but if the index falls, the investor bears both the interest cost and the decline in the index.

Property indexes used for the payments

Property indexes fall into two broad groups by the data they use: indexes built from transaction prices (median, hedonic, repeat-sales methods, and so on) and indexes built from appraisal values by real estate appraisers³. Indexes also divide into those that track price changes and those that track changes in investment returns.

The following is the situation as of 2007–2008.

In the UK, the commercial property indexes that IPD (Investment Property Databank) builds from appraisals have been used as the underlying of derivatives. According to a survey report by Japan's Ministry of Land, Infrastructure, Transport and Tourism (2008; the 2008 survey), the IPD UK data cover about 54.6% of commercial property (by asset value). IPD UK calculates total return, income return, and capital value return, is updated monthly, quarterly, and annually, and the 2008 survey says it has a highly transparent calculation model, so the parties trading share the view that it meets the requirements of a derivative underlying⁴.

In the US, the S&P/Case-Shiller Home Price Index, a housing price index, was already a derivative underlying. It was built with the repeat-sales method, which compares the prices of repeated sales of the same property, covered 10 US cities and the nation, and was published monthly⁵.

An index needs to meet certain conditions to serve as a derivative underlying. An index used for a derivative is generally said to need updates at least once a month. Trading parties need to transfer risk as it arises, so an index published once a year gives them little incentive to trade actively⁶. The 2007 report also lists representativeness, meaning how well the index represents the whole market or a part of it, as a necessary condition⁷.

Futures, options, and notes

Derivatives on property indexes take other forms besides swaps, as shown below. "Property derivatives" generally means three types: futures, options, and swaps⁸.

A futures contract fixes a future value now. If an owner sells futures, the owner gives up the gain when the index rises but reduces the loss when it falls. If an owner buys a put option, the owner stays prepared for a fall in the index and can still gain when it rises, but the buyer pays an option premium¹².

What property derivatives are used for

The following is the UK situation as of 2007–2008.

For property owners, the use is to adjust the size of the property position (exposure) without selling the property. A transaction in physical UK property usually took 1 to 3 months, and transaction costs were 1.5% of the price for a sale and 5.5% for a purchase¹³.

The sellers of property risk in the UK were mainly institutional investors such as life insurance companies. They used derivatives as a way to change their exposure without selling the property they held¹⁴.

The buyers are institutional investors such as pension funds. When they wanted to add property to a portfolio, there was almost no way other than investing in physical property, and transaction costs were high. The 2007 report considers that derivatives that deliver the return developed against this background¹⁴.

Using them can also work out well or badly. Company A, which entered the swap, limited its loss in the year the index fell but gave up the price gain in the year it rose. The investor gains if the index rises by more than the interest the investor pays (3% a year in the example), but loses if the index rises by less than that (in a year when the index is +2%, 2 − 3 = −1). If the index falls, the investor bears the loss from the decline plus the interest payment.

Tax changes also helped property derivatives become easier to use in the UK. A 2004 amendment allowed the gains and losses on property derivatives to be taxed together with those on physical property, which removed an obstacle for insurers and others using derivatives to hedge physical holdings¹⁵. In UK tax rules, conditions are set under which a property-based total return swap is treated as separate capital and income elements¹⁶.

Market size, liquidity, valuation, and hedging

The following is the situation as of 2007–2008 (except for the 2015 paper on valuation).

At the fourth quarter of 2007, the cumulative outstanding notional of trades on IPD indexes in the UK was about £9 billion (about 1.8 trillion yen). Compared with the UK physical property market of more than about 100 trillion yen, that is about 2%. Over-the-counter total return swaps dominated trading in the UK, and the volume of futures and options was considerably smaller¹⁷.

Exchange trading in the US was not large either. The open interest of CME S&P/Case-Shiller futures at the end of 2006 was 1,520 contracts, worth about USD 90 million (about 10 billion yen). Trading was less active than originally expected¹⁸. In Japan, no such product was listed, and contracts with functions close to property derivatives were not actively traded¹⁹.

Low liquidity makes it hard to find a counterparty and to close a position. In 1991, futures on a housing price index and on the IPD index were listed on an exchange in London, but the listing was withdrawn after about 5 months. The 2007 report names as factors a lack of mutual understanding between property and financial market participants, a lack of liquidity with no counterparties, and the reliability and publication frequency of the index (the IPD index at the time was published only once a year)²⁰.

On valuation, a 2015 paper analyzed 4 years of prices of UK IPD total return swaps. The paper reports that the traditional relationship between spot and forward prices does not hold for property derivatives. It also reports that the movement of forward rates is affected by interest rates, by the share prices of real estate investment trusts, and by the smoothing of the index, with the effect getting smaller as maturity gets longer²¹.

Futures prices can sometimes show where future prices are expected to go. For some time after listing, CME S&P/Case-Shiller futures traded about 10% below the underlying index. The 2007 report says this can be read as market participants expecting housing prices to fall by about 10%²². The 2008 survey says that once futures trading becomes active, the "forward curve" built from UK futures prices serves as information about the outlook for the physical property market²³.

Pricing options is said to be difficult. Where the liquidity of property derivatives as a whole is not very high, pricing the option premium becomes extremely difficult²⁴.

Hedging by the seller is also not easy in the physical property market. Delta hedging, in which an option seller trades the underlying again as its price moves, is expected to be hard in practice, the 2007 report says, because the property market is expected to lack the liquidity to trade freely and transaction costs apply. This leaves the issue that the risk on the derivative side cannot be offset by trading physical property²⁵.

Basis risk and other risks

One of the main risks of property derivatives is basis risk, where the gain or loss on the property held does not match the index payments. The table in "Annual payments and the total with the property" assumed that the property moves exactly with the index. Consider a hypothetical example in which, with the same notional, the property's total return differs from the index. Amounts in the table are in millions of yen.

In Year 1, the property beats the index by 3 percentage points, so the total rises from 300 million yen to 600 million yen. In Year 2, the property falls short of the index by 6 percentage points, and the total goes from a gain of 300 million yen to a loss of 300 million yen. In Year 3, the index and the property move together, and the total is 300 million yen. The gap can go in either direction.

Basis risk arises for three reasons. First, each property is unique, and the content of the portfolio held differs from the content of the index²⁶. Second, if the index covers a narrow range, the property held is more likely not to move with the index²⁷. Third, a gap arises when the frequency of observing property prices differs from the frequency of publishing the index²⁶.

There is also liquidity risk. If no one wants to hedge, property derivatives would become a market of only speculators and arbitrageurs, and liquidity could fall²⁸. Credit risk and other risks common to derivatives are covered in What Is a Derivative?.

What this page does not cover

Investment in property itself and real estate investment trusts (REITs) are not covered on this page.

Notes

1. HM Revenue & Customs, "CFM55100 - Derivative contracts - chargeable gains on derivatives - property based total return swaps (S650)", opening definition ("swaps changes in a property index, for an interest rate"). ↩

2. Ministry of Land, Infrastructure, Transport and Tourism, Real Estate Derivatives Study Group, "不動産デリバティブ研究会報告書" (Report of the Real Estate Derivatives Study Group, in Japanese; June 2007), section 3.3.2 2) "スワップ契約" (Swap contracts) (report page 42; PDF page 45). It covers the content of the swap, the term, the payments of the owner and the investor, and an example of an intermediary earning a fee. ↩ ↩²

3. Ministry of Land, Infrastructure, Transport and Tourism, Land and Water Bureau, Land Information Division, "平成 19 年度 不動産デリバティブの可能性とその普及・啓発に関する調査業務 報告書" (FY2007 Survey on the Potential of Real Estate Derivatives and Their Promotion and Awareness: Report, in Japanese; March 2008), 2-3-1 "インデックスの分類" (Classification of indexes) (report page 53; PDF page 55). ↩

4. The same report, 2-3-2 (1) 1) "IPD UK" (report page 54; PDF page 56). Coverage of about 54.6% (by asset value), update frequency, transparency of the calculation model, and the view shared by the trading parties. ↩

5. Real Estate Derivatives Study Group report, 3.3.2 3) "価格指数デリバティブ" (Price index derivatives) (report page 43; PDF page 46). Listing on the CME on May 22, 2006, the repeat-sales method, indexes for 10 US cities and the nation, and publication on the last Tuesday of each month. ↩ ↩²

6. The same report, among the index requirements, "流動性とフリークエンシー（更新頻度）" (Liquidity and frequency (update frequency)) (report page 63; PDF page 66). ↩ ↩²

7. The same report, the same place, "代表性とベーシス・リスク" (Representativeness and basis risk) (report page 63; PDF page 66), and the 2008 survey, Table 4.1 "不動産インデックスに求められる要件とその理由" (Requirements for property indexes and the reasons) (report page 92; PDF page 94). ↩

8. Real Estate Derivatives Study Group report, 3.2.3 "不動産デリバティブの種類と概要" (Types and overview of property derivatives) (report page 32; PDF page 35). ↩

9. The same report, 3.3.1 1) "イギリスにおける不動産デリバティブの現状" (The current state of property derivatives in the UK) (report page 36; PDF page 39). TRSs appeared from 2004. ↩

10. The same report, 3.2.3 2) "不動産オプション" (Property options) (report page 33; PDF page 36). The listing of options on futures on the CME is in 3.3.2 3) (report page 43). ↩

11. The same report, 3.3.2 1) "インデックス・リンク債" (Index-linked notes) (report page 41; PDF page 44). PICs developed by Barclays in 1994. ↩

12. The same report, 3.2.3 1) "不動産先物" (Property futures) and 2) "不動産オプション" (Property options) (report pages 32–33; PDF pages 35–36). Futures remove the risk of a fall but also the chance of a gain from a rise, and the buyer of a put option pays a premium. ↩

13. 2008 survey, 1-1-2 (report page 5; PDF page 7). A transaction takes about 1 to 3 months, with costs of 1.5% on a sale and 5.5% on a purchase. ↩

14. Real Estate Derivatives Study Group report, 3.3.1 1) (report page 37; PDF page 40). The sellers of risk are mainly institutional investors such as life insurance companies, and investors (such as pension funds) had no main method other than investing in physical property, with high transaction costs. ↩ ↩²

15. 2008 survey, 1-1-3 "不動産デリバティブ市場の発展の経緯" (How the property derivatives market developed) (report page 7; PDF page 9). Under the tax system at the time, gains and losses could not be offset, so the Users Association was organized in 2003 to lobby, and the system was amended in 2004. ↩

16. HM Revenue & Customs, "CFM55100", main text. Conditions include the specification of a capital value index, the separation of the 'capital' element, and the absence of a tax advantage as a main purpose. The content was checked in October 2026. ↩

17. 2008 survey, 1-1-4 (report pages 7–8; PDF pages 9–10). About £9 billion (about 1.8 trillion yen) in the fourth quarter of 2007, 2% of the physical property market, TRSs dominant, and futures and options considerably smaller. ↩

18. Real Estate Derivatives Study Group report, 3.3.1 2) "アメリカにおける不動産デリバティブの現状" (The current state of property derivatives in the US) (report page 39; PDF page 42). Open interest of 1,520 contracts at the end of 2006, about USD 90 million (about 10 billion yen). ↩

19. The same report, 3.2.1 (report page 31; PDF page 34). ↩

20. Real Estate Derivatives Study Group report, 4.1.1 "総論" (Overview), the summary of failures (report page 48; PDF page 51), and the 2008 survey, 1-1-3 (report page 7; PDF page 9). Listed on London FOX in May 1991 and withdrawn after 5 months. ↩

21. Pierre-Arnaud Drouhin, Yasmine Essafi, Arnaud Simon, "Forward Curve Risk Factors Analysis in the UK Real Estate Market" (HAL, 2015), abstract. ↩

22. Real Estate Derivatives Study Group report, 3.3.2 3) (report page 43; PDF page 46). ↩

23. 2008 survey, 2-1-1 (3) "先物取引の副次的効果" (Secondary effects of futures trading) (report page 30; PDF page 32). ↩

24. 2008 survey, 2-1-2 (3) "オプション取引の特徴" (Characteristics of options trading) (report page 34; PDF page 36). ↩

25. Real Estate Derivatives Study Group report, 4.2.4 1) "ボラティリティの更なる拡大の可能性" (The possibility of further growth in volatility), footnote 36 (report page 83; PDF page 86). ↩

26. The same report, 4.1.1, footnote 30 (report page 48; PDF page 51). Basis risk is the risk that the underlying price and the derivative price diverge, and it can arise when the observation frequency and the publication frequency differ or from the individuality of properties. Footnote 15 of the same report (page 29) also cites the possibility of a gap from the actual loss. ↩ ↩²

27. 2008 survey, 4-1 "不動産インデックスに求められる要件" (Requirements for property indexes) and Table 4.1 (report pages 91–92; PDF pages 93–94). The list of requirements is on page 91, and the statement that narrow coverage makes basis risk more likely is in the "代表性" (Representativeness) row of Table 4.1. ↩ ↩²

28. Real Estate Derivatives Study Group report, 4.2.4 2) "投機的なデリバティブ市場の可能性" (The possibility of a speculative derivatives market) (report page 84; PDF page 87). ↩