Property Futures and Securitisation–The Way Ahead

206 Pages·1995·10.68 MB·English

by  Julian Roche (Auth.)

Property futures and
securitisation —
the way ahead
JULIAN ROCHE
WOODHEAD PUBLISHING LIMITED
Cambridge England
Published by Woodhead Publishing Ltd,
Abington Hall, Abington,
Cambridge CBl 6AH, England
First published 1995
© 1995, Woodhead Publishing Ltd
Conditions of sale
All rights reserved. No part of this publication may be reproduced or transmitted,
in any form or by any means, electronic or mechanical, including photocopy,
recording or any information storage and retrieval system, without permission in
writing from the publisher.
While a great deal of care has been taken to provide accurate and current
information, neither the author, nor the publisher, nor anyone else associated with
this publication, shall be liable for any loss, damage or liability directly or
indirectly caused, or alleged to be caused, by this book.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library.
ISBN 1 85573 180 0
Designed by Andrew Jones (text) and The Colour Studio (jacket).
Typeset by BookEns Ltd, Royston, Herts.
Printed by St Edmundsbury Press, Bury St Edmunds, Suffolk, England.
Foreword
Property arouses emotions which other kinds of asset, such as shares and
bonds, do not. Who cares if the stockmarket is falling, except a small tribe
of City-types and company directors? Who cares if long-term interest
rates rise, except those fund managers who are holding bonds? Who cares
if house prices fall? The answer is two-thirds of the country's population.
Every house-owner is not only paying for basic comfort and shelter, but is
also an investor. Indeed, housing accounts for about one-third of the total
of all private assets in Britain (excluding human capital).
But it is not only residential property which excites: commercial
property has some spectacular 'ups and downs' as well. For example, it
remains to be seen whether Canary Wharf in London's Docklands is a
white elephant or a huge success. In the meantime, Olympia and York, the
main developer, has been bankrupted. Property companies tend to be
risky, all over the world, as the recent failure of Jiirgen Schneider in
Germany demonstrates. Each developer wants to leave a monument to
their own vision, but often they overreach themselves. The secondary
banking crisis in London in 1973 was precipitated by bad property deals.
All of the above argues that property is risky. Yet that is not the
perception of the average house-owner ('as safe as houses'), or of the
average chartered surveyor. I remember a conversation with a leading
agent in the City of London in 1988, in which it was argued that the
stockmarket might have crashed but commercial property would continue
to rise. He was soon proved wrong. There is a tendency to consider
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PROPERTY FUTURES AND SECURITISATION - THE WAY AHEAD
property as completely different from other kinds of assets - solid, visible,
reliable — which is quite mistaken. Property (either residential or
commercial) is about as risky in terms of price changes as a UK
government bond and it is certainly more risky than the $/£ exchange
rate. Yet property is not only risky, it is also hugely illiquid - it is very
slow and expensive to trade, so decisions cannot easily be reversed.
That is why the subject of this book — liquid property — is important.
Over the last decade there have been several attempts to make commercial
property more easily tradable — PINCs, REITs, APUTs and all the others!
If you are like me and cannot always remember the details, this book
provides a very convenient history and explains why most of the efforts
failed. The goal of these efforts is to develop an easily-tradable form of
standard property, so that those who want some property risk/return can
buy it and those that want to hedge can sell it. The difficulty is in finding
either the right portfolio of properties or a representative index to trade,
without incurring extra taxation or being exposed to highly-subjective
valuations.
The most interesting attempt to create an easily-traded form of
property (both commercial and residential) was the development of the
property futures market on London's Fox exchange in 1991. As a former
member of the team at the exchange, Julian Roche is in a good position to
explain how the contract developed and why it failed after six months. It
is a story which needs to be recorded, so that the same mistakes are not
made again.
This book should therefore help to explain how far the advance has
been made in the 'battle for liquid property'. It sets the scene for further
developments which undoubtedly will come, not only in Britain but in all
the major market economies.
Gordon Gemmill
Professor of Finance
City University Business School
London
vi
Acknowledgements
The debts I owe in being able to write this book are numerous and
substantial. Most obviously I owe to Mark Blundell the opportunity to
work at London Fox during that exciting but ultimately sad time. To my
colleagues there at that time, especially Simon Cleaver, Graham Wainer,
Victor Trocki and Jackie Ralph, and to the two consecutive heads of the
Business Development Department at London Fox under whom I worked,
Chris Kennedy and Jon Payne, I owe a debt of understanding and
tolerance of my ways. I am grateful to Stephen Barter, David Ryland and
Colin Vaughan for enabling me to begin to understand the complex world
of property securitisation, and to the members of the Practitioners'
Committee of the Fox property futures market for giving me a window
into the world of property. I owe to Ian Cullen of IPD and Barry Bissett of
Nationwide an especial debt in explaining to me the details of their
respective property measurement systems.
To Neil Wenborn I owe the original suggestion that I write this book,
and I am glad to see it come to fruition, even if not as a textbook on a
flourishing market as was hoped. I am very grateful to Mary Clark for her
hospitality during the writing of this book, and of course to Angela for
enduring the endless mixture of 'what ifs' and reminiscences that writing
this book has entailed.
vii
Introduction
As has frequently been observed. The innovation of new production
processes and the development of new products has long been recognised
as a key ingredient to improvements in economic welfare' (Silber, 1981:
p 123). Securitisation for property would, if successfully designed and
implemented and if it then gained widespread approval and use,
revolutionise both the property and investment worlds - it would make
property more like the stock market. To some extent real estate
investment trusts (REITs) in the US are already laying the foundation
for this, which is why their performance, especially from 1991 onwards,
repays close study. To some extent also, authorised property unit trusts
(APUTs) and the BZW property certificates have started the job in the
UK. Yet property futures would take the property market a stage further;
it has even been suggested that: The economic significance of index-based
real estate derivative markets, if they were to become well-established,
could well be much greater than that of all financial derivative markets
established to date combined.' (Case, Shiller and Weiss, 1993: p 91)
Securitisation has become something of a Holy Grail for a generation
of innovators in the property industry, and has become equally hated by
the guardians of the pagan ritual traditions of property investment, most
importantly the stewardship of illiquidity. Investors have been frightened
away from property by this illiquidity for decades but the property
industry has been utterly resistant to doing anything about the problem.
The Estates Gazette editorial of October 1993 put the issue very well and is
viii
INTRODUCTION
worth quoting from substantially as representing the current state of
thinking about securitisation in the property industry worldwide:
On the surface there appears to be no shortage of cash now being ploughed
into property. Investment activity is booming - £8bn could flow in this year
— and property shares are trading at premiums to net asset values. But it is
only prime property that really interests investors: covenant is king. And a
large question mark hangs over the financing of other categories. How will
development be funded and from where will the cash come to refinance the
overhang of existing underperforming property? Conventional lending to
the property sector has all but dried up as the banks retreat nursing the
wounds inflicted by their earlier excesses. It is imperative that new funding
methods are found if the sector is to have any hope of making a full
recovery.
Liquidity is the key. Make property more liquid and a new generation of
investors could be attracted to bricks and mortar. Splitting individual
properties, or even portfolios, into tradable securities would provide the
flexibility and choice which investors are looking for. Securitisation would
diversify the pool of funds which is available for property, leading to more
investors, more cash and more activity.
The theory, not surprisingly, has a familiar ring: securitisation first
surfaced in the mid-1980s, but to very little effect. The DTI reined in PINCs
just before they got off the ground, but then the market slumped and
demand with it, and SPOTs fell foul of the Inland Revenue.
Securitisation is now at least a more familiar concept, even if it has not yet
been used with commercial property in the UK. But it is only a matter of
time — in the US, real estate investment trusts are already up and running. It
seems that the banks seeking to hive off assets to maintain capital adequacy
ratios will lead the way. And, with the economy apparently on the upturn,
they need to sort out their balance sheets in readiness for renewed loan
demand. Getting existing loans off the books releases capital for lending on
more profitable projects.
Hitherto financiers held back from securitising commercial assets because
it can be a costly method of raising funds. Deals on residential and personal
loans, for example, such as the ones completed recently by Nat West and
Barclays, are slightly cheaper, whereas a commercial securitisation would
have to involve at least £l50m worth of property just to be cost-efficient.
However, with the property market picking up, assets will be easier to
securitise at decent margins and consequently banks are again thinking more
closely about the idea. With the groundwork under way, commercial
securitisation might well be a reality in the UK before the end of next year
(1994). (Estate Gazette, 10 October 1993)
This book is about attempts in the 1980s and early 1990s to make that
dream come true: about the history of that other venture in UK property
securitisation which the Estates Gazette tactfully omitted to mention -
property futures - about the relationship between them, about the future
for both concepts, and what can be done, if anything, to bring about a
liquid securitised spot and a futures market in commercial property.
Proponents of property futures both in the US and the UK have been
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PROPERTY FUTURES AND SECURITISATION - THE WAY AHEAD
as enthusiastic about the idea as the Estates Gazette was about
securitisation. Property futures markets, it has been claimed, could make
life better for so many of us:
Homeowners who are worried about their concentrated investment in local
housing; prospective homeowners who are worried about being one day
priced out of the market; renters who are concerned about rental costs and
availability of apartments; investors who want to diversify their portfolios to
include real estate; builders who want to hedge the risk inherent in their
business; and farmers concerned about their costs and risks. The markets may
well serve to smooth out the business cycle and allow more rational, even-
keel planning in all walks of life. (Case, Shiller and Weiss, 1993: p 91)
This book investigates these claims in detail.
x
CHAPTER
#
The concept of a
commodity, a market
and a derivative
What is a commodity?
Economists agree about what a commodity is. It is a portion of wealth for
which people are prepared to offer other commodities or money because
they need it to satisfy a need or want. There is inevitably scarcity and
therefore every commodity has a price. In this economic sense,
automobiles are obviously commodities in the same way that cocoa is.
Property, whether commercial or residential, is a commodity in the same
way. In international trade terms, and so far as derivative markets are
concerned, the term commodity has a much narrower meaning. Such
commodities are natural substances, sometimes processed but more often
just graded and sorted according to well-defined criteria. Such
commodities can be divided very roughly into the following categories:
• Metals.
• Soft commodities (such as cocoa, coffee, sugar, cotton and rice).
• Energy (mainly oil, oil derivatives and gas).
• Other.
This book is about the range of possibilities that may exist to treat
property the economic commodity as property a tradable commodity.
What is applicable to property will, in principle, be applicable to other
finished or semi-finished manfactures. London Fox (now the London
Commodity Exchange) conducted research into automobile futures at the
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PROPERTY FUTURES AND SECURITISATION - THE WAY AHEAD
same time as the property futures programme. The intention was to
investigate the feasibility of automobile futures once the property futures
market was up and running because there was, in principle, no difference
between the two.
Markets
Markets have been in existence for as long as commodities have been
traded, originally they existed between consumers and producers, but
gradually their intermediate role of merchant became more significant. The
main characteristics of a market are:
• The set time.
• The regular occurrence.
• The definite physical location.
• The existence of regulations governing the exchange of commodities.
• The maintenance of order.
The complex international commodity markets of the twentieth century
are direct descendants of these primitive markets, and perform the same
functions.
To analyse derivatives, the first distinction that must be made is
between a physical, or spot, market, and all derivatives. The physical
market need not be for a physical commodity — it can be for a government
bond, an insurance contract, a collection of mortgages or most certainly an
individual property or group of properties. The physical/spot market is
between a buyer and seller at time T for whatever commodity is being
bought and sold: the price paid is the price at time T, and ownership
passes with the payment at time T. Of course, anyone who has bought a
house, let alone a cargo of rice, will note wryly that the physical market is
never this simple. It is a complete mistake to imagine that all derivative
markets are necessarily more complicated than all spot markets just
because they are derivative markets. In practice, time T can be an extended
period. Property, in particular, takes time to sell between exchange of
contracts and completion, and in rapidly rising and falling markets this not
only provides an obstacle to trade but is also built into contracts.
Ownership passes on completion, too, rather than when the first of a
series of staged payments is made. The existence of mortgages
complicates the nature of the physical transaction still further. In the
terms of the derivative markets, however, when a house worth $100 000 is
2