This opinion piece looks at the valuation process and some issues raised by the introduction of a derivatives market in UK commercial property.

The fledgling market in commercial property derivatives is gaining increasing media attention and could potentially offer valuers a useful insight into how the market expects property values to evolve.

However, there are limits to the weight that valuers will place on the use of derivatives market data.

The growth of a derivatives market in UK commercial property could change the way valuations are carried out by surveyors on the ground, if the market gains sufficient liquidity and depth, although radical change is unlikely.

One idiosyncrasy of the valuation process is that the traditional and preferred method of valuation relies on using comparable evidence (which will always be retrospective in nature).

The illiquid nature of the direct commercial property market means that transactions are not observed on a frequent basis and a spot market does not exist. Indeed, even if buildings of a similar structure have been recently transacted in a locality, the nature of the deal may be opaque with covenants, incentives and lease clauses undisclosed.

It has been suggested that a forward derivatives price curve could facilitate valuations and increase accuracy by providing market forecasts for rents, yields and capital values on a daily basis.

Such forecasts could be incorporated into the valuation process and would provide a timelier indicator than current consensus-type surveys (such as those carried out by the Investment Property Forum) or retrospective transaction data.

Valuers currently use the IPD All Property Index and sub sector indices as a starting point for the valuation process.

These indexes – particularly the All-Property index – are the basis for Britain’s over-the-counter commercial property derivatives market.

Contracts are drawn up between two parties to "swap" a property based return in exchange for a return based on Libor plus a spread. Similarly contracts can be drawn up to "swap" sub sector returns where two parties have opposing views on the outlook for one of the sub sectors (retail, industrial or office).

This allows investors to gain a return from market movements or fine tune portfolio exposure, without needing to buy or sell the tangible assets within the underlying market.

However, valuers that RICS have spoken to suggest that there are several problems associated with the use of top-down data and consensus-type surveys in the valuation process.

As such, any forecasts generated from derivatives data would still encounter these problems which would need to be overcome, before widespread application by valuers could be adopted.

Composition and basis risk
Composition risk arises where participants within the commercial property derivatives market are not representative of the underlying market.

For the valuer to actually take notice of the property derivatives curve, movements of the curve need to be reflective of the changing perceptions off all market participants and not just a select few.

At present, the size of the derivatives market (£3.7bn in outstanding contracts) is too small to be reflective of the activity undertaken in the underlying direct market (£50bn).

However, developments in the shipping derivatives market over the last decade, serve to show that composition risk should erode over time.

A second area which lessens the usefulness of any derivatives market curve arises through basis risk.

Basis risk is where information obtained from the indices or index is too wide to be reflective of local market conditions or property types.

For example, an index which covers office property at a national level may fall 3% in the course of a year whilst the market in central London may have risen by 5%.

For a surveyor carrying out a valuation in the central London office market, the national index offers little useful information.

With these two hazards present in the data, understanding local market dynamics and risks will remain the domain of the valuer. He or she will be the final arbiter on the calculation of a local risk premium to attach to buildings.

The heterogeneous nature of the property market leads the valuer to place a much higher weighting on bottom-up analysis.

As such, the direct market is likely to continue leading the valuation process by providing comparable transactions for reference (where they exist).

Where comparable yields are hard to come by, the valuer may use discounted cash flow (DCF) techniques to arrive at a present-value estimate.

However, even when using the "income approach" to valuation, derivatives pricing is likely to be of low importance, due to the emphasis the income method places on building specific data in arriving at a suitable risk premium.

Employing the income method, the valuer will estimate an expected future income stream for a property and a discount rate to apply to those future income streams.

This discount rate will be composed of a risk-free rate, inflation premium and a relevant risk premium, and will be used to bring the value of these future income streams into today’s monetary terms.

To compute a relevant risk premium the valuer will:

• Estimate rental growth going forward
• Account for potential breaks – or voids—in an income stream
• Estimate any refurbishment and fit-out costs
• Calculate a future exit value or yield at which the property will be sold

Assuming the structural problems of basis and composition risk are overcome then a mature forward derivatives pricing curve could feed into valuers’ estimations for both rental growth and future exit yields and refine some elements in calculating a local level risk premium.

However, building-specific knowledge would still command a greater weight in arriving at a final estimate for a property risk premium.

In conclusion, the problems of basis risk brought about by the heterogeneous nature of the commercial property market will only be solved if index coverage expands to incorporate property at a regional, city and more importantly, local level.

However the problem associated with composition risk is likely to erode over time.

In the future
Valuers may pay less attention to derivatives prices in the early stages of development but the market is set to evolve.

If market activity trends in the shipping industry are replicated in the commercial property sector, it is not unrealistic to expect around £25bn (50% of underlying) of derivative deals to be carried out, as a wider net of investors feel comfortable with the product and its performance attributes.

However, shipping derivatives have taken over a decade to become an established market and whilst volumes are growing, the UK commercial derivatives market remains a fledgling one.

Should the commercial property derivatives market reach an advanced stage of maturity, then it has been suggested that the price signals from the forward market could act as a tempering influence on investor behaviour.

However, greater frequency and increased transparency of data does not necessarily prevent the build up of an asset bubble.

Derivatives pricing will be based on investors’ perceptions of future returns which may or may not be rational. For example, an active derivatives market in the equity sector did not prevent the dot-com bubble.

With a mature derivatives forward curve, economic/political events and news would be quickly disseminated into market pricing.

One potential benefit would be that valuers, in the event of a shock, could take into account property derivative pricing where there is a lack of comparative deals in the cash market (although adjustments would need to made for any liquidity premium in the synthetic market).

In summary therefore, we do not expect a commercial property derivatives market to hugely change the valuation process in the near future though it still represents a positive step for the industry by promoting greater activity in the underlying market.

This article was published on Reuters real estate website in December 2006.

RICS valuation faculty (e valuation.faculty@rics.org) would welcome any comments, feedback or opinion related to derivatives and its likely impact on the valuation process.