The nascent US property derivatives market is expected to attract much more interest from US and foreign investors following a recent ruling by the US Internal Revenue Service that reduces taxes paid on such investments.

The IRS decision “opens up the industry dramatically”, said Philip Barker, senior vice-president at GFI Group in New York. GFI, a derivatives brokerage firm, which has teamed up with CB Richard Ellis in the US and the UK to help develop the property derivatives market in both countries.

Mr Barker said trading in property derivatives in the US lagged far behind than in the UK. “It’s occurring here, but it’s slow. In the UK, it has advanced at a much faster pace,” he said. Estimates are that only about $2.5bn in both commercial and residential property derivatives have traded in the US over the past two-plus years, compared to £7.2bn ($14.2bn) worth of such trades in the UK last year alone.

Last month’s IRS ruling removes an uncertainty that had surrounded property derivatives: they are now not considered “real property” for tax purposes. That means the more stringent tax laws that apply to foreign investors in US property – most notably a 10 per cent withholding tax on the proceeds of a deal – do not apply to investors in derivatives.

Property derivatives – typically involving over-the-counter trading in swaps, options or futures based on the returns of a property index – allow an investor to gain or limit exposure to real estate.

Development companies, pensions or other institutional investors with property holdings, and hedge funds are derivatives’ prime users. Experts in the US said the property derivatives market remained under-developed.

“We generally favour having such tools available to add flexibility and liquidity to our investor real estate programmes,” said Rob Kochis, principal at property investment consultancy Townsend Group. “But that market is in its infancy in the US and not yet developed to the point where it has been useful.” 

Mr Barker from GFI believes the IRS ruling will change that. He expects a sharp uptick in property derivatives investing from the UK and other countries. That will add a needed jolt of liquidity to the market, prompting more US investors to join in. “We’ve arranged a number of deals for pension funds and portfolio managers,” Mr Barker said. “But there are scores of people sitting in the sidelines, waiting for the market to develop in terms of liquidity.” 

Also slowing the development has been the lack of a dominant index for the derivatives to be based on. However, there are now generally agreed-upon indexes for both the commercial and residential sectors – the National Council of Real Estate Investment Fiduciaries Property Index and the Residential Property Index, respectively – and this has served to accelerate trading. And the recent sharp price drops in both of those sectors could push some investors toward derivatives as a hedge against further declines.

Scott Brown, principal and head of global property at investment consulting firm Ennis Knupp and Associates, also thinks that development is coming. “The real estate derivatives market in the US is young, and I fully expect it will develop and become more robust as investors become more comfortable with the capabilities and contracts,” he said. The “more favourable tax treatment” for foreign investors, he added, “should serve to accelerate the growth”.

The UK market began to grow when a few large pension funds announced they had hedged their property portfolios with derivatives, Mr Barker said.

“In the US, we’ve had nothing of the sort. Most of what we’ve seen has been under the table, with no real transparency.” 

The tipping point, he thinks, will be when the US market sees “a few high-profile trades” that encourage other investors to take the plunge as well.

The US market for property derivatives could one day be a $1,000bn industry, though it’s tough to say how long that may take, Mr Barker noted. “It’s difficult to make any forecasts. But we and CB Richard Ellis believe this asset class needs and is ready for derivatives to help expand the opportunities that are out there.”

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