Derivatives are financial instruments whose price and value derive from the value of the underlying assets (such as equities or interest rates) or other variables (such as the weather) (for a feature article on derivatives generally, see "Derivatives uncovered: swaps, futures and all that jazz", www.practicallaw.com/9-201-2879).

Property derivatives are derivative contracts that derive their value from land and are based on a property returns index. The type of derivative used in the Quintain deal was a swap: a contract between two parties to exchange cash flows for a stated period of time.

Forward selling a property derivative contract means agreeing to sell the derivative at a future date at a stated price.

An example of a property swap is where Investor 1 agrees to pay floating rate interest to Investor 2 in return for a property-related return based on a property index (see box "Transaction diagram").

Investor 2 may or may not have an underlying portfolio of property that approximates to the profile of the selected index (in much the same way that Investor 1 may or may not have an underlying cash deposit which pays interest at a rate that matches its obligation to pay floating interest).

As with all derivatives, the benefits depend on the investor's view of the market. In this example, the interest return will be LIBOR plus or minus a spread and investors take a view based on what they think will be happening in the future to interest rates and the property market.

In the property market, derivatives are particularly attractive, as James Dakin, a partner at Nabarro Nathanson who advised Quintain on the deal, explains: "For clients, there are lots of interesting opportunities opening up. Property derivatives offer them a quick and cheap way of getting exposure to the property market."

Users of property derivatives fall into two main categories:

There were two parts to the Quintain deal:

The typical three-year term of property derivative contracts means that, to date, the party wanting to obtain the property-related return has been tied in to receiving that return for three years. For investors, this has meant that property derivatives have been an inflexible investment tool.

By forward selling the second and third years of the swap, Quintain was able to obtain a property-related return for a single year. It is thought that this sort of flexibility will make the derivatives market more liquid and so encourage more deals.

The documents were based on the International Swaps and Derivatives Association (ISDA) standard but there were some special features in the confirmations. These were mainly to deal with the peculiarities of the property index.

The all properties total return index of the Investment Property Databank (IPD) has been the index typically used in property derivative transactions to date. The index includes data on actual property transactions from institutional investors and property companies. The information is collated over the course of the year and an annual figure for the total property return is produced.

This leads to an asymmetry in the payment obligations because the index-linked property-related returns are annual payments, while interest payments are quarterly. This means that the confirmation needs to provide for three quarterly payments in one direction and a single annual payment in the other.

It is expected that IPD will begin to produce quarterly figures early next year, which will eliminate this asymmetry.

Two key developments are expected:

Some commentators have suggested that real estate investment trusts (REITs) would be a more practical substitute for property derivatives. Originating in the US, a traditional REIT is a tax-transparent corporate entity that buys, develops, manages and sells real property; it allows participants to invest in a professionally managed portfolio of real property that is held for long-term benefit.

The Treasury has consulted on the possible introduction of REITs in the UK and an announcement is expected in the Pre-Budget Report on 5 December 2005 (www.practicallaw.com/8-200-5539).

The experience in markets such as Australia and the US where REITs are well-established is that, in contrast to derivatives, REIT prices move more in line with stock market sentiment than with underlying property prices. Property derivatives are based on actual property returns, through the index, so their value fluctuates in accordance with underlying property prices.

The prevailing view in the UK is that the two investments would therefore be broadly complementary. "The development of deep and liquid markets for both property derivatives and REITs will complete the "toolkit" that the UK property market needs to stay as one of the most sophisticated property markets in the world to the advantage of participants and occupiers alike," says Simon Clark,head of European Real Estate at Linklaters.

According to research carried out this year by Nabarro Nathanson, CB Richard Ellis, the commercial property consultant, and GFI Group, the derivatives broker, most of the participants in the property derivatives market that were surveyed thought it likely that an increase in activity in the property derivatives market would follow the introduction of REITs in the UK.