Asia-Pacific property derivatives could open up emerging markets

It has been revealed that ICAP, one of the world’s largest traders of financial instruments, has been in talks with a number of parties to create an Asia-Pacific property derivatives market which could be up and running in just a few months.  The operation will allow investors to buy and sell exposure to the underlying property markets of the region without actually buying bricks and mortar.

This will open up countries such as Morocco to the international property investment market and attract some of the largest property players in the world to the country.  While there are already many kinds of financial derivatives available, how do property derivatives work? What are the risks? What are the benefits?

Derivative markets in general

In theory the derivatives market will allow investors to buy or sell an exposure to any market in the world where there is an underlying product or service and there are buyers and sellers.  There are many different forms of derivatives which is why the market has literally mushroomed over the last twenty years into the multi-trillion dollar markets we see today.

The major derivatives markets are for currencies and these literally turn over hundreds of millions of dollars a day.  As with any market there are two main parties, those who are trading for their underlying business and traders / investors who are dealing with a view to selling the derivative for a profit.

Property market derivatives

As property markets around the world continue to grow, more and more investors have been looking at emerging markets such as Morocco where property prices have performed very well in recent times.  Morocco for example has seen a massive increase in tourist numbers and extensive investment by the government which has seen a significant improvement in many local services.  These are the perfect building blocks of a substantial long term investment market but time can often be of the essence and many fund managers and investors are loathe to go through the property purchase and sale procedures, instead looking to trade derivatives offering exposure to the general market and specific niches.

In simple terms, if there is some form of trustworthy property index, whatever country or area of the market this relates to, it is in principle possible to create a derivatives market where traders can buy and sell based upon the property index alone.

Liquidity

Unfortunately not all indexes or markets are suitable for derivative operations because in order to create and operate an orderly market there needs to be liquidity, something which we have heard a lot about of late with regards to the money markets.  When you consider that some property derivatives in more developed property markets will trade billions of dollars of derivatives a year, these will prove attractive to investors because there it is highly likely that there will be a buyer or seller (at a price) at any time.

Can you imagine the situation where you have purchased a derivative and are now looking to sell it into the market for a profit, it would be no good to you if there were no buyers around, if the market was illiquid.  You would have a paper profit but not actually be able to crystallise your gain, leaving you open to market movements or being forced to sell at an unreasonable price.  Liquidity is the key to any market in the world whether you are buying or selling shares, property investments or derivatives.

Benefits of property derivatives

There are many benefits to property derivatives, some of which we have touched on above, but the main benefits are the speed at which you can increase or reduce your exposure to any market.  Rather than going through the long winded process of physically buying a property you can just buy a derivative which is based upon the movement of a reliable property index.  It is the same when selling a derivative and both options will see reduced costs compared to physically buying and selling property.

Drawbacks of property derivatives

As a derivatives market needs to be liquid and can sometimes be tricky to set up there is every chance that investors will have to trade in a minimum size to make it worthwhile for the parties on both sides of the deal. This can often eliminate small private investors from the picture although one option would be to invest directly into property funds which are involved in derivatives in the market(s) to which you want exposure.

Why the Asia-Pacific region?

While the Asia-Pacific already has a number of developed property markets there are also many emerging markets appearing which are proving of interest to investors.  It is this option to mix and match the exposure of any property fund using derivatives which is proving attractive and in theory allowing fund managers to very quickly move between markets as and when they see fit.

Thankfully, after a number of difficult situations the property sector has seemingly grasped the idea of creating property based indexes which reflect the overall trend in general or niche markets.  These are the basis of the derivatives market and they need to be a true reflection of the underlying market(s) and large enough so that they cannot be manipulated by any one or group of investors.

Even for those looking to acquire physical properties, the derivatives market can be very useful as it offers a snap shot of the market and makes it easier to compare trends and movements.

Conclusion

Many people have a distinct dislike of financial derivatives as they are often caught up in the volatile movements of the markets without truly understanding the nature of the beast.  Derivatives can also be used to hedge a position and allow investors to crystallise gains or realise losses quicker than you could do in the more traditional property markets – they are not just for speculators!

That is not to say that property derivatives are for everyone as investors do need to understand how they work and be able to monitor them to get the best out of the market.  They do however offer a very interesting exposure to niche markets or general markets where it could be near impossible to replicate the derivatives position by physically acquiring a number of properties.