Real estate is the last major asset class without liquid derivatives markets. The reasons for that are not fully known or understood. Therefore, the aim of this paper is to better understand the main factors that influence the propensity of commercial real estate investors in the U.K. to employ property derivatives.

The research methodology that was chosen for the this research is grounded theory which, in its original form, goes back to Glaser and Strauss (1967). A total of 43 interviews were conducted with real estate professionals in the U.K. from property investment management firms (investing directly or indirectly in real estate), multi-asset management firms, real estate investment trusts (REITs), banks, and brokerage and advisory firms, among others.

The research results show 29 factors that influence the propensity of direct and indirect real estate investors in the U.K to employ property derivatives. Out of the 29 factors there are 12 with high explanatory power, six with a contributing role and 11 with low explanatory power. Moreover, factors previously discussed in the literature are tested and assessed as to their explanatory power. The focus of this paper is on those factors with high explanatory power.

From the research data, three main reasons have been identified as the sources of investor reluctance to trade in property derivatives. The first and main reason is related to a mismatch between motivations of property investment managers and what can be achieved with the instruments. The second reason, which ties in with the first one, is a general misunderstanding as to the right pricing technique of property derivatives. Finally, the third reason is a general lack of hedging demand from the investor base owing to the long investment horizons through market cycles.

The research contributes to the literature on property derivatives in various ways. First, it extends the literature on market hurdles in property derivatives markets by testing and extending the hurdles that were proposed previously. Second, the research shows that the existing price models need to be extended in order to account for the risk perception of practitioners and their concerns with regard to liquidity levels.

For both theory and practice, the research has shown some limitations in using property derivatives for purposes such as creating index exposure or hedging.