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Property derivatives – case Hedging development risk

Property derivatives – case Hedging development risk. Case – hedging development risk.

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Property derivatives – case Hedging development risk

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  1. Property derivatives – caseHedging development risk

  2. Case – hedging development risk • It is late in 2006. HotCo, a property development company, is developing a project with total estimated costs of £120m. The project involves the construction of a 100,000 sq ft London West End office building. • On completion, the developer will sell the completed development at market value. Completion and sale is planned for late 2008. • The initial development appraisal envisaged an average letting value of £85/sq ft and a resale capitalisation rate of 6.25%. On this basis, the scheme had an anticipated development value of £136m (100,000 * £85 / 6.25%).

  3. Case - hedging development risk • The average letting value at late 2006 had already reached £80psf. The market was strong, and the estimated capitalisation rate for the scheme at that point had fallen to 5%. The development value at the point was £160m (100,000 * £80 / 5%). • However, due to commodity price inflation estimated costs had risen to £130m. Nonetheless, the strong market meant that at that point the scheme remained profitable. • At the end of 2006, market returns had been strong, but the development company felt that a downturn was a strong probability.

  4. Case: consensus scenarios The 2 year IPD swap price was 10% in December 2006

  5. Case – action? • The price of buying a two year IPD total return swap at December 2006 was 10%. • What action could the board take in late 2006 to manage its risk? • The price of buying a two year IPD total return swap at December 2006 was 10%. • Assume the developer sells IPD exposure for this price. Its exposure to date is £130m, so it could go short £130m.

  6. Out-turn – if the market strengthens • In December 2007 (or early in the following year) HotCo will receive 10% on £130m = £13m in payment of the fixed leg. It will pay out the IPD total return for 2007 of 20% on £130m, or £26m. Net swap loss for 2007 is £13m. • The 2008 out-turn is a 20% return on IPD. In December 2008 HotCo receives £13m for the fixed leg and pays the IPD total return of 20% on £130m = £26m, producing a net loss of £13m.

  7. Out-turn – if the market strengthens • The completion value of the scheme in a strong market is high at £170m, with capitalisation rates down to 5% and rents firm at £85. (100,000 * £85 / 5% = £170m.) • HotCo’s net position is a profit on the project of £40m, plus a swap loss of £26m. This creates a profit of £14m compared to a do-nothing (no swap) profit of £40m.

  8. Out-turn – if the market remains strong • In December 2007 HotCo will receive 10% on £130m = £13m in payment of the fixed leg. It will pay out the IPD total return for 2007 of 10% on £130m, or £13m. The total gain/loss for 2007 is zero. • The 2008 out-turn is a 10% return on IPD. In December 2008 HotCo receives £13m for the fixed leg and pays the IPD total return of 10% on £130m = £13m, producing a net gain/loss for 2008 of zero

  9. Out-turn – if the market remains strong • Capitalisation rates have remained low at 5.25% and the rent is again firm at £85/sq ft. The completion value of the scheme is around £162m (100,000 * £85 / 5.25% = £161.9m). • HotCo’s net position is a gain on the project of £31.9m, plus a swap loss of zero: this is a net gain of £31.9m compared to the same do-nothing gain.

  10. Out-turn – if the market weakens • In December 2007 HotCo will receive 10% on £130m = £13m in payment of the fixed leg. It will pay out the IPD total return for 2007 of zero. The total income for 2007 is £13m. • In December 2008 HotCo will receive 10% on £130m = £13m in payment of the fixed leg. The 2008 out-turn is a zero return on IPD. It will pay out the 2008 total return of zero and the total income for 2008 is £13m.

  11. Out-turn – if the market weakens • In the now-weak market, capitalisation rates have reverted back to 6.25% and the rent is lower at £80/sq ft. The completion value of the scheme is now £128m (100,000 * £80 / 6.25% = £128m.) The project now makes a loss of £2m. • The combined position is a loss on the scheme of £2m plus a swap gain of £26m: a net gain of £24m (compared to a do-nothing loss of £2m).

  12. Case: out-turns

  13. Case: result • The swap has a neutral effect on the average and probability-weighted out-turns. A profit is made in all three out-turns, which is not true if no swap is put in place, and the range and standard deviation (risk) of returns is reduced.

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