Using Futures To Hedge Your House

by: Hard Assets Investor

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
(Sell Short 16 Contracts)

$495,000

(Index @ 138.00)
$552,000

-$57,000

Hedge Lifted
(Cover 16 Contracts)

$391,000

(Index @ 110.40)
$441,600

-$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
(Sell Short 16 Contracts)

$495,000

(Index @ 138.00)
$552,000

-$57,000

Hedge Lifted
(Cover 16 Contracts)

$500,000

(Index @ 140.00)
$560,000

-$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.