Using Futures To Hedge Your House
By Brad Zigler
The most important asset for most investors won't be found in their brokerage accounts. Investors, rather, can be found living in it. "A house is more than just a home," says an old adage. Indeed, it's often the single largest investment an individual makes.
The influence a home's value has on personal net worth is being felt more keenly than ever before. It's long been easy for investors to manage the risks of their securities portfolios; hedging vehicles abound for stocks and bonds. Until recently, though, there wasn't a direct hedge for residential property. Safeguarding real estate wealth with short sales of real estate investment trusts [REITs] or the stocks of home builders has been, at best, a hit-and-miss proposition. REITs, for example, track bond and equity prices much more closely than home values.
So why would anyone need a hedge in the first place? Why not just wait out a down cycle? Well, some people just can't wait to sell. Job changes or military reassignments, for example, may require moves to be made at inopportune times. Executors or heirs of estates, too, may need to liquidate property holdings as quickly as possible to meet settlement benchmarks.
Options Abound
Options for hedging the hardest of hard assets multiplied when a suite of cash-settled futures contracts based on S&P/Case-Shiller housing indexes were recently launched on the Chicago Mercantile Exchange. The Merc contracts track 10 metropolitan markets - Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco and Washington, D.C. (as well as a U.S. composite).
Using these contracts effectively requires investors to exercise the same care employed when using stock index futures to hedge an equity portfolio.
First of all, there's basis risk to consider. Basis risk represents the tracking error between a contract's underlying index and the value of a given home. A compensating factor - a beta of sorts - has to be derived to adjust for the idiosyncrasies of a particular market in which a home is located. For instance, housing prices in California's Napa Valley Wine Country are 1.13 times as volatile as those in San Francisco, some 50 miles to the south, according to research from National City Corp. A housing futures contract is priced at $250 times the underlying index. If, for example, the San Francisco index is now at 159.40, the value of a contract based upon the Bay Area benchmark would be $39,850. Thus, to fully hedge the median-priced ($685,400) San Francisco home against a price decline, 17 contracts should be sold. To fully hedge a median-priced ($432,200) Wine Country home, 12 San Francisco contracts ($432,200 ÷ $39,850 contract value × 1.13 beta) would have to be shorted.
To see the degree of protection afforded, let's suppose a Wine Country resident intends to sell his $495,000 home within, say, seven months when he's due to be transferred to another job locale. Fearful of an intervening decline in the value of his home, he could hedge his sale price with a beta-adjusted position in February 2009 San Francisco futures, now priced at 138 index points. If his house eventually sells for $391,000, his hedge might produce results like this:
Hedging Against Declining Home Value | |||
| (Long) Home Value | (Short) Futures Notional Value | (Long) Basis |
Hedge Placed | $495,000 | (Index @ 138.00) | -$57,000 |
Hedge Lifted | $391,000 | (Index @ 110.40) | -$50,600 |
Net | -$104,000 | +$110,400 | +$6,400 |
In this hedge, the entire loss in market value was offset and a little extra ($6,400) was earned, to boot, from a favorable change in the basis. As the result of hedging, the home owner's effective sale price was $501,400 (the $495,000 target price plus the $6,400 netted from the hedge transaction). Not all hedges can be expected to turn out like this.
If one can lock in their sale price with this kind of hedge, you'd think there'd be a line of anxious sellers in front of futures brokerage firm doors. What keeps lines from forming, in part, is the expense of the "insurance" cover. The initial margin requirement for the San Francisco housing contract is presently $2,025, meaning a total of $32,400 in cash or T-Bills must be deposited to open the position. Even though the transaction is used to reduce a home owner's risk, hedge margin rates aren't available to noncommercial accounts, so a substantial amount of capital must be dedicated to supporting the position.
Hedging comes with another potential cost. If real estate values bottom out or even rise while a hedge is in place, the home owner's effective sale price can be reduced, as illustrated here:
Hedge Results In A Flat Market | |||
| (Long) Home Value | (Short) Futures Notional Value | (Long) Basis |
Hedge Placed | $495,000 | (Index @ 138.00) | -$57,000 |
Hedge Lifted | $500,000 | (Index @ 140.00) | -$60,000 |
Net | +$5,000 | -$8,000 | -$3,000 |
As the result of hedging, the seller nets only $492,000 for his home - less than he could have obtained if he remained "uninsured." More important, though, is the cash flow consideration. The home's value is only realized upon its sale - a transaction months away from the hedge's placement. The complementary futures position, however, is marked to market daily: Losses are realized as they occur. Our home owner faces a margin call if futures settle just 2.20 index points above his 138 selling price.
The $3,000 setback illustrated is actual cash out of pocket, offset only when the home is sold. This illustrates the need to constantly monitor market conditions to determine if a continuing hedge is necessary.
That shouldn't be a problem, judging from the talk I hear. It seems most people are already closely monitoring the market.
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This article has 23 comments:
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Owen
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138 Comments
Aug 11 01:54 PMSince the hedger will hold the position until expiration, the cash settlement will ensure accurate pricing on position closing, but leaving 2-2.5% in the hands of a market maker to enter the position is probably more than what most home owners--or speculators--are willing to pay.
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Buprestid
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16 Comments
Aug 11 02:45 PM-
User 241974
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1 Comment
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Aug 11 03:29 PMYou're future home price is going to settle somewhere between the Ceiling (top)and the Floor (bottom). Whether it's closer to Ceiling or Floor depends upon and number of factors.
The Ceiling identifies the top price in an area based on what the local incomes will support. When you do the math and realize 80% of homes are purchased with a mortgage and sensible lenders will only permit a borrower to use 28% of their gross income for mortgage payments you'll deduce that a home price of 4 times the neighborhood income is the Ceiling or the highest prices can be in a normal area.
How far can prices fall? On the bottom end of the home valuation is Floor or the value of the house as an income producing asset.
You can find out the Ceiling and Floor values for your zip-code by going to ushousingmeltdown.org/....
In bubble areas, my guess is prices will settle closer to the Ceiling. In these areas, demand is not the issue, it's affordability.
In economically depressed areas, best guess is prices will settle closer to the Floor or even below it.
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Malkiel
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592 Comments
Aug 11 03:29 PM-
Owen
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138 Comments
Aug 11 03:53 PMVolumes in the CME real estate products are low firstly because it is a new product. However, I doubt volumes will pick up unless the contract structure is changed. The CME repeated the mistake they did with the Renminbi currency product.
When the CME introduced the futures contract for the Euro currency in the late 90s, they came up with a single product, and four quarterly expirations a year. This concentrated essentially all the liquidity in the futures product in the two or three front contracts, and trading soon picked up and is now on the order of hundreds of thousands of contracts a day. With the Chinese Renminbi, the exchange introduced three sets of contracts: The Renminbi against the US dollar, against the Euro, and against the Japanese Yen. Furthermore, they introduced monthly expirations, spreading the little liquidity available among a dozens of contracts. As expected, none of the Renminbi futures contracts were able to garner enough liquidity to get off the ground, and to this day the RMB contracts on CME barely trade, with daily volumes usually under 10.
What the CME fails to see is that financial products are not like ice cream; a single well-designed product will generate far larger volumes than an offering of 31 different flavours.
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Managing Editor
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130 Comments
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Aug 11 04:03 PMYou're absolutely correct about liquidity. To get a 16-contract position in SFR (the San Francisco housing contracts), you have to be a scale-down seller. Total open interest in that particular contract is only 58 contracts.
Buprestid -
Hard to say if liquidity will increase. Largely, a new futures product succeeds when people know about it. Publicity, save for that generated around the launch, has been pretty spare. Individuals, too, may be scared away from futures thinking that it will only increase, rather than decrease, risk.
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JulieSBK
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1 Comment
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Aug 11 05:58 PM-
MarkMedayski
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32 Comments
Aug 12 07:11 AMAlthough the idea is good to hedge your house,but it can be done simpler by selling 2 big SP500 futures contracts,or 10 miniSP contracts.
This way your are in the liquid market,can go in/out whenever you decide and margin requirements are the same.
Your house will go down in price only if economy will weaken,of course it will,so hedge not only your house,hedge your life by going short the SP500 futures.Close them when they will be 40% below and even then I am not sure it will be a good deal.
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nickgogert
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238 Comments
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Aug 12 08:59 AM-
Managing Editor
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130 Comments
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Aug 12 09:29 AMWith each index point worth $250, a contract priced at 138 points would represent a value of $34,500. The $2,025 bond required would actually mean margin's 5.9%.
Still, having cash on hand to meet maintenance calls (recall from the article that a 2.20-point adverse move could put the trader into margin call territory) is always prudent.
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Managing Editor
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130 Comments
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Aug 12 09:46 AMHedging home values with the S&P 500, or other cross-hedges, introduces extraneous risks. There isn't a good correlation -- positive or negative -- between blue-chip stock prices and housing values. A study of long-term relationships between stock prices and housing values conducted by the Chicago Mercantile Exchange found the correlation to be -39%. That's a pretty dirty number for someone to rely upon when selling a house.
Nobody likes dealing with big spreads, but you can't automatically blame market makers. In order to attract order flow, a trader putting up a two-way market must make bids or offers attractive in relation to competing traders and the attendent risks. If there are few options for the market maker's own hedge, spreads tend to be wide. That's the case with the housing futures.
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Owen
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138 Comments
Aug 12 12:07 PMMarkMedayski's comment about his 40% exit condition and "hedging your life" makes it clear he is not talking about a hedge at all. An actual hedge is left in place until the underlying asset is liquidated, regardless of the price movement of the individual legs of the hedge. All MarkMedayski wants to tell us is that he thinks the S&P-500 is about to drop 40% or more. Why he chose to post it as a comment on this article is anybody's guess.
Your point about the weak, negative correlation between house prices and equities is very good. Between 2000 and 2003 the S&P dropped 45%, while US home prices increased significantly. In fact, a negative correlation means you are better off _buying_ S&P futures to hedge your home value, although again the poor correlation makes such a strategy futile. Do you have any numbers about the correlation between home prices and the yield on the 30-year bond?
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notsosmart
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1244 Comments
Aug 12 12:28 PM-
Managing Editor
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Aug 12 01:29 PMThe CME's long-term study found the correlation between housing values and bonds to be -17%.
Notsosmart -
Thanks for the reminder of a house's utility. However, the old adage still rings true: it's MORE than just a home.
The difference between a renter (one who seeks only the utility of shelter) and a homeowner is akin to the difference between buyers of term and whole life insurance. The term buyer seeks only one utility: insurance; the whole life buyer wants more: the insurance cover AND an investment return/borrowing facility.
To speak in the terms you used, it's the HOME that's the asset and the HELOC is the liability. But there's no guarantee that a home WILL put money in your pocket. If you're forced to sell early, before your property has a chance to appreciate, or if the real estate market is soft, you can, in fact, LOSE money.
Even in a normal market. That's where a hedge comes in.
The home represents POTENTIAL wealth, only to be realized upon its sale, assuming its value appreciates above the purchase price and the encumbrances lodged against it.
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notsosmart
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1244 Comments
Aug 12 03:55 PM-
Gustafsen
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3 Comments
Aug 14 12:31 PM-
Managing Editor
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Aug 14 07:31 PMYou're right to note that a hedge carries a cost.
You hedge away the opportunity for a windfall profit if real estate values increase. If, however, your basis (the difference between the nominal value of the futures position and the home price) stays relatively stable, the gain on the home should, to some degree or another offset the loss in futures, allowing you to realize something close to your target sales price.
The net effect of hedging isn't the ELIMINATION of risk; it's the SUBSTITUTION of a large, unknown price risk for a smaller, more predictable basis risk.
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Gustafsen
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3 Comments
Aug 15 02:54 AMIf we take an extreme example, where you buy a house for $500k and hedge it to try to keep it to a target price of that $500k.
Then, let's say there is a huge price movement upward. Prices quadruple So now the house is worth $2M and with your hedging strategy you net around $500k. When you look to buy a comparable house from the one you just left, you now need to produce $1.5M from your own pocket, because that comparable house now costs $2M.
The target price could be substantially higher, and, due to incomplete hedging, your actual return could be substantially higher than that, and the increase in prices could be substantially below 4X, and you would still need to produce a huge amount of money to buy another house.
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Managing Editor
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Aug 15 02:35 PMThe object of the hedge is lock in, as much as possible, the target price. You'd only be compelled to hedge if you felt the market was soft enough to warrant the trouble. If you felt, instead, that prices were likely to rise, you'd remain unhedged.
Once hedged, you're not locked in 'til contract expiration. You can lift the hedge by offsetting the contracts through a covering purchase. From that point forward, you can enjoy unhedged gains on your appreciating property.
Hedging can done in steps as well. Farmers have been doing this for generations, hedging only a portion of their crop at a time. The degree of hedge coverage may increase as the growing season progresses and as pricing conditions and yields are better known.
Just consider the unhedged portion of your property as a form of "self-insurance,&... akin to the deductable that reduces policy premium.
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Gustafsen
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3 Comments
Aug 15 07:00 PMThere seems to be four points you are making:
1. Target price. If you assume purchase price = current price = target price = $500k, I think my example still holds.
2. Feelings. Of course you wouldn't hedge when you felt the market was strong, but feelings are often wrong. In fact, they are generally the opposite of what they should be, which explains why purchase volume peaked at the top of the housing market and why volume is generally very low at market bottoms.
3. You can lift the hedge. Well, sure you can lift the hedge, but then you are unhedged from that point forward. Let's say the value of your home goes up to $700k. Now you are +$200K on the house and -200K on your short futures position, for net $0. So you go long on the future at that point to exactly counter the short position, and you are thus even.
But let's say prices descend from there and the house is back to being worth $500k. On the house you would be net $0, on the original short you would be net $0, and on the countering long that you bought when the house was worth $700K, you would be -$200K. Wouldn't you lose $200K in that scenario?
4. It can be done in steps. Yes, but then this negative stuff would happen in steps. If you take all the steps, you would lose all the money you would if it you took one big step. If you skip enough steps to make a difference in your potential losses, you are unhedged to the extent it can create a substantial loss for yourself if prices fall during those steps.
What am I missing?
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Owen
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138 Comments
Aug 15 07:49 PMHere's another example, along Gustafsen's lines: you bought a house for $300k. Prices rose to $500k, which you decided to pick as your target hedge level, entering the futures contract. However, prices then continue to rise further to $800k. At that point you realize your mistake, and your only option is to meet the margin call (or actually the negative open equity on the contract) by selling your house for $800k, and closing out the futures position for a loss of $300k. You are left, as expected, with $500k. The hedge worked properly, but now you can't afford a new house!
Of course, you could also meet that margin call by taking a (second) mortgage on the house. The amount you'll need is exactly the value of the house minus $500k, so again once you decide to close the position, you'd be left with the same $500k of equity, which may or may not be enough to own your home.
If you only entered the hedge when "you felt the market was soft", as Managing Editor suggests, then you are not actually hedging at all; you are speculating. Nothing wrong with that, as long as you realize this strategy will backfire if prices move up, leaving you with same dollar value, but less "house" than you started with.
The hedging strategy may be useful when the property is a pure investment. You plan to rent it out, and want to ensure your fixed rent income isn't eaten up by a depreciating property value. In that case, rising real estate prices don't bother you, since you are still getting the same return on your original investment--or possibly better, as rent often rises alongside house prices. Due to the hedge you will not be able to enjoy the capital gain in the value of the property, but you are also protected from any depreciation due to falling home prices. Rising prices will eventually force you to sell the property and close the hedging position, but your original investment will be intact, ready to be deployed in another field.
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Managing Editor
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Aug 15 11:45 PMTake an agricultural example: I'm raising corn. It's still months before harvest. The bid in my local market is $6/bushel, a price that would cover my production costs and afford me a profit. Since my corn's still in the ground, though, I can't sell at that price. By the time my corn's ready, so too will be all the corn grown by my neighbors. The large supply at harvest, holding all other factors in abeyance, will likely depress prices. I can sell futures now, however, as a substitute for the later cash market sale to lock in today's price. When my corn's ready, I can lift the hedge and sell the crop locally.
If you're not forced by circumstance to sell your home, you can wait unhedged for the right to time to sell. But if, as posited in the article, you're obliged to sell because of a job relocation, or to settle an estate, the hedge can help you lock in today's price. For an executor, in fact, the 'prudent man' rule may, in fact, MANDATE a hedge.
I'd take issue with the statement: "if you only entered the hedge when 'you felt the market was soft' ... you are not actually hedging at all; you are speculating."
A farmer uses judgement in deciding a hedge strategy. He/she doesn't hedge by rote. Based on bids in the cash market, assessments of probable supply and weather forecasts, hedges MAY be adopted. There are plenty of times, however, when producers remain unhedged. Using discretion in the placement of hedges doesn't make the hedge a speculation. FARMING is speculating; using futures to manage price risk is hedging.
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genjuro911
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1 Comment
Dec 13 07:58 PM