a Real Estate Decline
by David Stanowski
10 July 2007
So, what can you do now if you didn't sell your residential real estate near the top in 2005-2006, and it's too late to get the price you wanted? In California, many neighborhoods have already seen prices drop over 20%, and it's a long way from the bottom. What if you believe in the buy-and-hold strategy, or just don't want to sell a certain property? If you don't want to suffer through a white knuckle flight, for the next few years; you hedge!
Hedging is the process of transferring some, or all, of your risk to another party. It is a form of insurance.
The futures markets were developed hundreds of years ago to allow farmers to hedge the risk on their crops. Over the years, futures contracts have been developed in many other markets. Thanks to the efforts of Professor Robert Schiller, the Chicago Mercantile Exchange now has futures and options contracts on residential real estate!
Short Hedge - Producers
If a farmer is growing 50,000 bushels of wheat, and the current price is $4.00/bushel, how can he make sure that he gets $4.00 at harvest? He sells (goes short) 10, 5,000-bushel wheat contracts. He only needs to put up a small deposit (margin) to do so.
At harvest time, if wheat is selling for $2.00/bushel, he receives $100,000 less than he wanted, but his futures contracts show a profit of $100,000; so by hedging, he has locked in his price! If the price was above $4.00, he would make more on his crop, and lose on his futures contracts, but the result is the same.
Long Hedge - Consumers
If a bread company needs to buy 50,000 bushels of wheat, in two months, and the current price is $4.00/bushel, how can they make sure that they don't have to pay more than $4.00? They buy (go long) 10, 5,000-bushel wheat contracts. They only need to put up a small deposit (margin) to do so.
When they need to buy the wheat, if wheat is selling for $6.00/bushel, they pay $100,000 more than they wanted, but their futures contracts show a profit of $100,000; so by hedging, they have locked in their price! If the price was below $4.00, they would pay less for the wheat, and lose on their futures contracts, but the result is the same.
Both of these hedges were "perfect hedges" (50,000 bushels of wheat hedging 50,000 bushels of wheat), because once they are put on, the outcome is guaranteed no matter what prices do. All risk has been eliminated by forfeiting the option to speculate that prices MIGHT move in your favor. However, most hedges can not be this exact.
Many airlines have finally learned that they need to hedge their jet fuel costs against rising prices. However, since there are no jet fuel futures contracts, they have to use heating oil contracts as a proxy. Heating oil does track jet fuel pretty closely, but this is an imperfect hedge. There is still some risk that the difference between heating oil and jet fuel prices might deviate more than expected.
Real Estate Hedges
Currently, the CME trades futures and options contracts on residential real estate price indexes in 10 major cities, and for the U.S. as a whole. This means that none of these contracts can precisely track any one property. Using these products will be an imperfect hedge. In addition, since they are new, they are still thinly traded. However, they certainly have the potential to be very useful in lowering the risk of holding real estate!!
CME: Info on Real Estate Futures
CME: Real Estate Contract Specs
For example: Let's consider the case of someone who bought a condo, last year, for $400,000, in Broward County Florida. This flipper hoped to sell it this year for a big profit, but just learned that there is an 84 month supply of inventory in Broward, and prices are dropping fast. He sees the high probability of selling at a very big loss, or even losing the condo in a foreclosure.
Our flipper decides that prices in Miami should correlate fairly well with Broward, so the Miami contract should be the best one for him to use as a hedge. He calls his broker, and finds out that Miami residential real estate futures are trading at 270, or $67,500 per contract. He sells short 6 contracts $67,500 x 6 = $405,000. The required margin per contract is about $1,000-2,000; so he needs $6,000-$12,000 in capital to put on the hedge. Margin is just a performance bond, and it is returned when the positions are closed, after the P/L of the position is settled.
In late 2007, our lucky flipper sells his condo, for $225,000, and takes a $175,000 loss. However, he also covers his short Miami futures contracts, which have gone down almost as much. The profit on his futures contracts is $160,000! Now, his total hit is only $15,000; not $175,000!
This is why the big guys are always hedging their investments in a whole range of markets!!
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Does Hedging Make You a Chicken?
There are also techniques where options on these real estate futures can be used to achieve protection from price declines. Another imperfect hedging method would be to sell short funds holding homebuilding stocks, such as XHB and ITB. These can only be margined up to 50%, so more money is required, and the correlation is going to be more imprecise, than with futures, and options.
The XHB topped in March 2006 and has declined 35%, so far, during a rising stock market; so it appears to be working as a general hedge against a declining real estate market. The ITB only began trading in May 2006, but it has declined 40%, so far!
Unlike the simple buy-and-hold strategy, of investing in real estate, used by many people, hedging properly does require an actual market forecast, and a rigorous analysis of all the options.
1. The investor needs to search out and analyze all the current market data to decide whether a 20-50% decline in the price of his property is likely during the current cycle.
2. If the need for a hedge seems likely, the investor should find a knowledgeable futures broker to help him examine his hedging options; including all the risks of an imperfect hedge.
3. The investor needs to make sure that he has sufficient capital to ride out a rise in the market while he is holding a short hedge.
The creation of futures and options, on residential real estate indexes, has created a golden opportunity for Realtors to form partnerships with futures brokers who can help them create hedging solutions for their clients. A Realtor who can help their clients hedge, until a property is sold, is going to have a very unique and valuable service, that few others can offer. Can you imagine what it would mean if you are the only Realtor, in your area, who can do this?
DISCLOSURE: The author is the Managing Partner in a Limited Partnership that currently holds short positions in the stocks of home-building companies.
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