New residential property index for derivatives

Steve Moore of GFI Colliers in Hong Kong talks to FinanceAsia about creating the regionÆs first residential property index for derivatives products.
Hong KongÆs active property market must make it a good candidate for building derivatives products, right?
Yes, the beauty of the Hong Kong market is the turnover û each unit transacts on average every 3.2 years, whereas in the UK or Australia itÆs more like seven years, and there are 100,000 transactions on average every year, so thereÆs just a huge amount of data to work with.

A fairly straightforward for job you then?
Not quite. The problem in Hong Kong is that the big landlords don't feel the need to benchmark their properties û theyÆre performing so well so they donÆt see the advantages of portfolio analysis. In the UK, Investment Property Databank (IPD) provides a transparent benchmarking source and, as confidence has grown in its numbers, it has built an index that now comprises 88 sub-sectors. GFI has been writing total return swaps against the IPD indices for about two-and-a-half years in the UK, and will eventually replicate those swaps for the commercial sector here in Hong Kong as the landlords views on portfolio analysis and transparency are slowly changing through the efforts of IPD. For the moment commercial indices for derivatives will have to wait but we are extremely excited about the applications residential property derivatives will bring to the property town that is Hong Kong.

After talking to some people at Colliers we eventually ended up contacting Hong Kong University. Professor KW Chau, the chair of the real estate and construction department, has written papers on property indices around the world and had developed a Hong Kong residential index of his own, so that was our starting point.

How much work was involved in producing an index suitable for derivatives?
It took the Professor eight months to collate the data. The investment bankers want something stable to provide a platform for derivatives, so we had to allow Professor Chau the time to create a model that would produce a reliable number.

We are lucky in Hong Kong that the raw data is readily available from the Land Registry. Residential property indices elsewhere in the world, such as the Halifax House Price Index in the UK, are based on valuations, but in Hong Kong we have a public record of every residential transaction each year (85,000 on average), so itÆs fairly easy to get a very accurate idea of the capital appreciation.

The trick, presumably, is to create a model that makes sure youÆre comparing apples with apples?
Right. But apartments, which make up the bulk of the residential sector in Hong Kong, are fairly uniform anyway. You canÆt build a swimming pool out the back or add a conservatory and hence change the value of the unit, so we can be fairly confident when a property transacts that it is pretty much the same property as before.

The real work we needed to do on the model was to make sure the data wasnÆt skewed by abnormal transactions. So, for instance, we discounted flats that hadnÆt changed hands for more than 10 years and those that had been sold on within two months of purchase. Primary sales are often an unfair representation of the residential market, so we only count repeat sales, which we define as flats that have transacted twice, or for a primary unit three times since development. At the other end of the spectrum, we discounted under-valued sales û a father selling to his son, for example, is typically not charging a market rate.

Obviously, Hong Kong is not a single geographic market from Lo Wu to Stanley, so how does your index carve up the territory?
There are four indices: Hong Kong Island, Kowloon, the New Territories and a weighted average of the three: the HKU All Residential Price Index. And itÆs actually quite surprising to see the variance between those markets. The indices are based at 100 in January 2000 with historicals dating back to July 1991. ItÆs interesting to see the New Territories is still well below 100, at 86, while Hong Kong Island has recovered to a level above the 2000 figure, so thereÆs definitely scope to trade these markets against each other.

What kind of response has there been from the market?
WeÆve been out marketing this product to the investment banks, hedge funds, commercial banks, but thereÆs really no limit to who might be interested. Derivatives can provide quick, hassle-free exposure to property or they can be used to hedge downside risk. The possibilities are almost endless.
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