The Information Content of Property Derivatives

1. The Information Content of Property Derivatives

2. Is information in IPF consensus consistent with derivatives? • Motivation: IPF consensus forecast widely followed measure of market expectations • But derivative prices also a source of return expectations. • Which measure of expectations has been more accurate? • Two related projects sponsored by EPRA and the IPF through its 2006-2009 Research Programme.

3. UK property derivatives • Long history of derivative products in the UK. • Regulatory and tax constraints inhibited market until 2005. • Total return swaps market emerged 2005. • Until end of 2007 – swap against 3m LIBOR • After 2008, return swap of annual IPD

4. Extensive literature on derivatives pricing • Buttimer et al (1997), Bjork and Clapham (2002 ),Baum et al (2006), Fisher and Geltner (2007), Patel and Periera (2008), Syz and Vanini (2008) • But literature on analyst behaviour and herding also relevant (e.g. Clement and Tse 2005, Trueman 1994)

5. IPF Consensus forecasts • Every 3 months • 30 (approx) forecasters: • property fund management, equity broking, and agency and consultancy sectors • IPD total returns, capital and rental growth • Forecasts - each of the next 3 calendar years and the 5 year average • Forecasts were compiled 3-4 weeks prior to the submission deadline (on average) • Results published (approx) 2 weeks after the deadline for submissions

6. Evolution of the IPF Consensus current year total return forecast

7. Implied return calculations • Solve for final cash flow that sets NPV of cash flows to zero. • eg. 2007 contract on 30 Jan 2007, 160bp margin • £10m notional contract • Implied return: 9.4% (incl risk premium) 31/12/06 31/3/07 30/6/07 30/9/07 31/12/07 15/3/08 30/1/07 Cash settlement based on annual IPD index release 3m LIBOR + margin/4 3m LIBOR + margin/4 3m LIBOR + margin/4 3m LIBOR + margin/4

8. Data • Derivatives prices (approx) weekly from Feb 2006. • LIBOR (BBA and Bloomberg) • Implied forward rates calculated from interest rates • Risk premium from Bond et al 2006

9. Implied returns for UK market

10. Comparison of outcomes

11. MSPE of forecasts for calendar 2006 by date of forecast MSPE of forecasts for calendar 2007 by date of forecast MSPE of forecasts for calendar 2008 by date of forecast

12. Variation among forecasters? • Fund managers: • comparable record relative to derivatives market for one and two quarters out • Generally better when derivative market lagged to reflect when forecasts made • Superior long term forecasts (two or three years) • Property advisers • comparable record relative to derivatives market for one quarter out • Equity brokers • Least accurate of the groups (even for short term)

13. Issues • Derivatives prices should be more efficient given larger number of participants in market • Certainly true for other markets but maybe not property • What is the economic significance of “forecast” errors? • MSPE might not be the best measure of evaluation • Lagging results to allow for when forecasts were made

14. Other research • Impact of valuation smoothing • Preliminary results reveal this to be important • Derivatives vs listed real estate market • Speed at which information is incorporated • Sources of error in IPF forecasts • Decomposed into rental growth and risk premium

15. Conclusion • Information obtained from the derivatives market provided a more accurate indication of future property return outcomes than did the IPF consensus forecast. • the derivatives market responded more quickly to the downturn than the IPF Consensus • Results changed when correction made for timing of forecast • Generally, around the time of release the derivatives markets have incorporated information.