Derivatives in the hotel industry

The Financial Times reports on bankers turning to derivatives to exploit the divergence in outlook for commercial real estate between the US and the UK. Derivatives are financial instruments that derive their value from an underlying asset. Heretofore, that has been limited to bonds, equities, currencies and commodities. Its extension to real estate brings on a new dimension and arguably could change the fundamentals of the industry as it likely will bring considerably more volume to transactions currently limited by the physical and logistical difficulties of entering and exiting real estate markets in a timely fashion. The nimbleness and concurrent liquidity – not to mention fees to bankers – afforded by derivatives presents tremendous opportunities.

The article notes that property prices in the two markets are opening up opportunities for “relative value” trades which are bets on the performance of different markets that are based on differing opinions for economic prognoses. Apparently, these trades were not possible mere months ago as the market for property derivatives took off only this March when four (unnamed) banks signed up for a license to trade the securities. The derivative contracts are comprised of instruments (swaps) when one party bets that real estate returns will exceed a pre-set benchmark like LIBOR (London Inter-bank Offered Rate) while the counter-party bets that it will not. So far, the trades, estimated globally to be about $20billion, have been broad commercial real estate and may or may not have included hotels. But it presages interesting times for hotel owners skittish – or not – about their asset values in these uncertain times.