The staggering weight of institutional and foreign investment in the UK property market has actually had the effect of limiting perceived investment opportunities for traditional property companies and trading developers

Appreciating land values and increased competition have pushed some of the more established UK companies to diversify their investment strategies to include different asset classes and take a longer-term view in order to reach their desired returns.

We are seeing the trend for these UK and foreign institutions, funds and family offices to develop a broad range of strategies to invest in yield generating, long-term UK property assets, including operational developments with the potential to deliver both long-term fixed or index-linked income and real capital returns.

This has amounted to an increase of ‘held’ operational assets, which inevitably expose investors to a rise in interest rates.

Therefore, investors or even developers of longer-term property assets may be wise to consider their options around hedging future asset value, to protect against movement in interest rates, which could easily erode the asset exit value, profit and ultimately internal rate of return of an investment, if term interest rates rise.

Furthermore, if a developer intends to retain an asset longer term, any future interest rate rise would also affect affordability — as interest cover ratios will naturally be impacted by higher costing funds.

One way a developer protects against interest rate risk is using an interest rate swap, as it is the most liquid market instrument. Swaps can be tailored exactly to the profile and duration of risk and development project, which makes them very useful to developers and investors who expect rates to rise at a particular point in the future. This could be used, for example, to hedge the interest rate risk at the point at which a developer sets the price to an investor.

Another way is to purchase an option known as a swaption. This involves the payment of a premium and offers the developer the right, but not the obligation, to enter into a swap at a predetermined strike rate, under which the developer will pay fixed and receive floating interest rates. The swaption allows the developer to hedge the interest rate risk to the value of his asset with a known downside risk (the initial cost of the swaption).

In a high-interest-rate environment, we wouldn’t necessarily expect there to be an increase in demand for swaptions because as rates start to rise, the yield curve will likely steepen to a more normalised shape. Also, we would expect volatility of interest rates markets to pick up in this environment and as such options become more expensive.

In our view, purchasing options is best when expectations of rate rises are relatively benign and markets are calm — there is less ‘implied’ chance of the option paying out and so it is a cheaper form of protection.

So when are they a better choice than swaps? Any option will have a break-even point — the premium is known and so you either benefit versus a swap whereby rates remain low or even move lower. However, if rates move higher then you would have been better off if you had just entered that swap. The beauty of the option is that it provides maximum flexibility and it is a right, but not an obligation to do something.

Whether people should consider this option depends on how sensitive your internal rate of return on equity is to movements in interest rates. The more highly geared a development or asset, the more important this is.
In summary, real estate developers and investors are in part at risk to movements in term interest rates based on the fixed nature of their income streams. Sophisticated fixed income managers are currently hedging what is termed the “duration risk” of their assets, ie the risk of higher rates eroding value.

The concept is less well explored with many real estate developers, however the risks are similar and the solutions are equally valid. Through a well-thought-out hedge strategy, real estate owners are able to reduce their price/value sensitivity to these fluctuations in term rates as risk-free rates move away from their all-time low levels.

Our view is it’s worth spending time exploring all the options.

Hayley Scott, structured property finance, and Andrew Lillywhite, deputy head of treasury, products and distribution at Investec