Stress Test

In the aftermath of the subprime meltdown, how are property-sector CFOs coping?

Rather, many CFOs believe that their priority is to making improvements to risk management. To help them, some are turning to derivatives — fortunately not the exotic instruments that played such a big role in the subprime fiasco, but those based on property prices.

In fact, swaps on the Investment Property Databank’s real estate return indices are gaining considerable traction in Europe, though trading remains small in comparison to other derivatives. By the end of 2007, €14.4 billion had been traded in the UK, Italy, Germany and France, up from €5 billion in 2006. In the first three months of this year, €4.6 billion of the derivatives were traded, increasingly by property companies, in addition to traditional users such as banks and institutional investors.

Since early last year, Grosvenor Group, a privately held UK company that owns and manages property worth nearly £13 billion in 16 countries, has been testing the waters by executing small trades in the instruments. Nick Scarles, Grosvenor’s finance director, says property derivatives are a good way of reducing the risk of its investments and developments, and perhaps also for its fund management business.

There is another attraction. Derivatives allow the firm “to gently shift the balance of asset allocation globally” from one country to another and “to give us the luxury of time to find the right asset” in a particular market, says Scarles. As he explains, “To migrate capital takes time — it is easy enough to have a fire sale and to bid at an auction — but you can overpay and undersell. By using derivatives, we can speed up the process of shifting portfolio allocations.” At an individual company level, he says, Grosvenor will use property derivatives for hedging purposes — for instance, in its development business in the UK it might use sector derivatives to hedge out long-term projects.

Grosvenor has started out small, “to make sure that we understand the documentation [in each new jurisdiction], accounting, how to measure counterparty risk and provide our team with experience if we have a trade at a more material level,” says Scarles, who was appointed chairman of the Property Derivatives Interest Group earlier this year. And reflecting the current mood of the sector, Grosvenor is cautious. “If my background had not included derivatives and treasury, I would not feel comfortable in the course that we’re taking,” he notes.

Wall of Money

Other CFOs may feel that such instruments are a step too far in today’s climate. Many will prefer to wait and see how the current cycle evolves, particularly given that many observers believe that, though the banks are currently on the sidelines, there is “a wall of money” — as one property lawyer describes it — raised by funds waiting to invest in the sector. “Although both equity and debt [will be] tighter than last year,” nearly two-thirds of respondents to the Urban Land Institute and PwC survey expect there to be “enough — or even a moderate surplus — out hunting for European real estate when the market settles down.”

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