Financial Innovations in Property Markets – Implications for the City of London

Citation

Ooi, J. (2003), "Financial Innovations in Property Markets – Implications for the City of London", Journal of Property Investment & Finance, Vol. 21 No. 2, pp. 201-202. https://doi.org/10.1108/jpif.2003.21.2.201.1

This report presents findings drawn from a research project commissioned by the Corporation of London. Carried out by three distinguished academics from the University of Reading and in association with the RICS Foundation, the broad aim of the project was to analyse the potential for, and the impact of, innovations in the financing, funding and procurement of property. The authors had originally set out to conduct three detailed case studies of innovative deals but they did not materialize due to limited access to data and information – a problem which many of us are familiar with. The 61‐page report is divided into six chapters.

The second chapter reviews the structure of the UK property market and the traditional model of financing and funding of the supply of space. For non‐UK based readers, the chapter provides an excellent, yet succinct, overview of real estate financing practices in the UK. The reader is also introduced to the “institutional lease” structure, which has the following features – long term, strong constraints on surrender and assignment, repairing obligations and upward‐only review clauses. The authors suggested that in the modern day business environment where ability to respond to changing market environment is essential for corporate survival, the current institutional lease is an onerous form of occupation. Nevertheless, this inflexible form of occupation has been preserved by valuation practices that penalize properties let on non‐standard terms.

In the third chapter, the authors went on to review the attempts to introduce flexibility and innovation into the UK property market. Similar to developments in other countries, the initiatives have centred largely on securitising real estate, commercial mortgage‐backed (CMBS) and asset‐backed securitisation (ABS) deals done in the UK in since the 1990s. Several prominent sale and leaseback deals involving J. Sainsbury, Shell and Abbey National were also discussed in the context of introducing off‐balance sheet ownership structures for corporate real estate. Due to the inability to obtain tax transparency status for equity investment vehicles, limited partnership has been a useful structure to avoid double taxation in the UK. The growth of property‐related derivatives, however, has been slow. In addition to the UK initiatives, the authors also examined the US market to see what lessons could be drawn from there. Not unexpectedly, they concluded that the particular form of real estate vehicles resulted from a combination of market conditions, market structure, tax and legislation.

The authors devoted two chapters on possible sources of value creation through financial engineering. The fourth chapter develops a theoretical framework, which was employed in the fifth chapter to evaluate recent financial initiatives observed in the UK property market. I have done some readings and research in this area and my views on the real worth of financial innovations are: First, they are costly and to justify their continuing existence, the new packaging (form) must provide value add to their users. Second, the “substance” of a deal is still the underlying real estate assets. Third, the “form” may enhance the “substance” only in the presence of market imperfections, such as in the presence of transaction costs, taxation, agency costs and information asymmetry.

The authors approached the evaluation in a similar fashion. Relying on consensus findings in the mainstream finance literature, they pointed out that the capital markets are broadly efficient, and it is difficult to create new financial initiatives that will yield superior returns to shareholders. As a result, most financial innovations are zero NPV initiatives. Hence, the authors’ statement that financial sophistication does not necessarily lead to added value. As pointed out earlier, value creation can only come about through the exploitation of inefficiencies in the marketplace. In this chapter, the authors debunked some common fallacies and questioned the real advantages of financial innovations. The claims tackled included benefits such as lower interest rates, off‐balance sheet financing, and higher loan‐to‐value financing.

In the concluding chapter, the authors reiterated that the prevailing bias against non‐institutional lease structure in the UK is a major stumbling block to financial innovations that needs to be overcome. The authors, nevertheless, noted with optimism the emergence of a breed of finance‐led property professionals that has emerged in the UK, who are less influenced by the traditional concerns of the valuation profession. In the long run, the introduction of innovative products would stimulate a more efficient real estate market that assists in the efficient allocation of resources in the economy.

Overall, the study has achieved the objectives set out. Personally, I have derived much pleasure reading the report. The report is well written and structured, and the content is very informative. The issues covered are pertinent for both practitioners and academics in providing a useful theoretical framework based on sound economics. The toolbox can be adopted to examine the sources of wealth in a proposed financial initiative. The issues covered are also relevant to audience outside the UK.

A copy of the report can be downloaded from the City of London’s Web sites at: www.cityoflondon.gov.uk/business_city/research_statistics/reports