Cover your basis: hedging real estate risk

April 11, 2007

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Since the turn of the millennium, real estate has become one of the fastest growing investment sectors, not just in the United States but globally as well. The gospel of property investing has penetrated every corner of the world from mature economies to developing countries -- a result of the revolution in real estate investment vehicles created over the past two decades to meet investor demand.


That's the good news.


On the downside, the vast amount of capital looking for a home has crushed yields, while in the United States, which continues to be the leader in financial engineering for the real estate industry, the bursting of the residential housing bubble has created a whole new set of problems for owners and lenders. All this turmoil suggests a need for hedging instruments. Unfortunately, this is where U.S. and international real estate markets lag.


As much as we would like to think otherwise, there's considerable risk involved in real estate investing and one of the ways to ameliorate that risk is through hedging practices, say two people who should know, Robert Edelstein, a real estate professor at the Haas School of Business at the University of California, Berkeley, and Anthony Sanders, the Bob Herberger Arizona Heritage Chair in Real Estate and Finance at the W. P. Carey School of Business.


"Hedging is a potential market and we will get there some day," says Edelstein, speaking about the global real estate market. Addressing the problems of the U.S. mortgage industry, Sanders adds, "Adjustable-rate mortgage resets will be over $300 million in 2007. If nothing else, this is an indication of why there is a need for hedges in this market. (On a reset, individual mortgage payments generally increase, which could push subprime borrowers into default.)"


Edelstein and Sanders made their comments at an April 5 seminar in Phoenix entitled, "Frontiers in Real Estate: Hedging Your Bets," presented by the Center for Real Estate Theory and Practice at the W. P. Carey School of Business.



Global markets: the shift toward risk


For Edelstein, who takes a global view of the property markets, "real estate is in a comfortable place right now," due to a number of key factors: global growth has meant individual economies such as in the United States are exhibiting strength, stability and resiliency; capital markets favor real estate; except for a few headline-grabbing instances, corporate profits and balance sheets are relatively pristine; and in a low-interest rate, low-return, low-volatility world "relative" return expectations provide support for real estate investment demand.


Estimates for the total value of global real estate go as high as $14 trillion or as low as $6 trillion, with 38 percent of that in North America, 37 percent in Europe; 20 percent Asia; 3 percent Latin America; and 2 percent the Pacific.


The drivers for the internalization and integration of real estate markets include technology, transparency and financial engineering which has created securitized assets and a better real estate investment trust product. In fact, Edelstein considers securitization "an inexorably sea level change," but he likes other developments as well, such as the spread of REIT markets around the world, with particular success in Japan, Korea and Singapore. He thinks the next major step in regard to international property markets will be China attempting to securitize its residential real estate. Says Edelstein, "the biggest single asset class that exists in China is the housing stock."


The trouble with globalization, Edelstein adds, is that it has always been a multi-edge sword. One of the big problems today is that a "capital tsunami" has washed over the worldwide property markets and this wave doesn't intend to recede so quickly. "There's no end to capital flow in sight (at least for the next six months)," Edelstein declares. "There is so much wealth generated globally, the world is yield-starved. That's why people are doing things you would not have expected."


What Edelstein means is that there has been a shift in risk. Back in 2000, real estate investors preferred core, stable or at the most risky, value-added investments. In 2006, there was a shift away from core to more opportunistic and value-added investments -- the riskier plays.


That is one reason why real estate derivative markets -- the lynchpins for hedging -- are almost here, he exclaims. He goes on to list a number of indices either in the development or planning stages by such groups as National Council of Real Estate Investment and Fiduciaries, Standard & Poor's (residential and commercial), and Real Capital Analytics, and for particular markets or sectors such the IPD Index for London, a new hotel index and Hong Kong real estate index.


"Everyone and their grandfather and sister will have an index," laughs Edelstein, "so there will be plenty of opportunities for hedging." On the buy side, the derivatives potential comes from demand by pension funds and other institutional investors, foreign investors, REITs, portfolio investors and even hedge funds. On the sell side, lenders, institutional owners, CDO (collateralized debt obligation) and CMBS (commercial mortgage-backed securities) managers as well as hedge funds, speculators and REITs can derive some benefit from derivatives.


And the reason for all this interest in real estate investment hedging? Answers Edelstein, "there is more risk now than there was five years ago."



Conditions ripe for hedging in U.S.


If there are some clouds on the horizon for international property markets, then the future is already here in the United States. In the spring of 2007 that has meant an over-arching consternation about the residential real estate market and the mortgage financing instruments associated with that market. This turbulence will eventually lead to the creation of a vehicle that could hedge house price risk, says Sanders.


The U.S housing market, Sanders sums up, looks like this: inventories of new homes and time on market for existing homes has increased and this has led to a slowdown in house price appreciation in most markets.


Looking at the data on a national basis, Sanders points out, annual house price growth started a steep slide south around 2005 after about a 13-year run of improving numbers. This is actually a consistent pattern, as sharp rises in U.S. home prices inevitably are followed by downtrends. The only real ugliness in the present downturn, says Sanders, is that for the first time since 1950 home prices actually experienced negative growth.


Don't panic, Sanders exhorts, as home prices have probably hit bottom and should be trending upward again this year. Besides, there are other positive omens in the universe. While it's true there is a residential inventory problem in the United States with more than a six-months supply of new homes on the market, this is actually lower than in the early 1990s when the last real estate bubble burst and much lower than the 1980s during what Sanders called, "the Jimmy Carter\Fed disaster."


Part of the problem, Sanders continues, is that home price appreciation was so great that by 2003 it had outpaced per capita disposable income. Basically, that means housing prices outran income generated by households, so to meet mortgage payments, families have had to cut back elsewhere or lose their homes. When this happens, Sanders adds, it is usually a "signal for housing prices to come down."


Residential markets don't stand alone. The decade-long boom was partially a result of cheap financing, creation of new mortgage products and an outreach to customers who would not normally qualify for housing. While the mortgage industry helped fuel the boom, it is also partially responsible for the bust.


For example, financial engineering resulted in a host of new mortgage types, such as adjustable-rate mortgages with year CMT (Constant Maturity Treasury). If you were unfortunate enough to have that kind of loan, your monthly payment on a $150,000 loan balance will increase 68 percent between 2005 and 2008, says Sanders. For a one-month, option-ARM with negative amortization, the increase will be an unbelievable 165 percent from 2005 to 2009. There's a product called the Smart30 I/O (10-year interest only, 20-year amortization and fixed for 30-years). If you own this type of loan, from 2005 to 2014, expect a 42 percent increase in your mortgage payment. "This should probably be called a Dumb30 I/O," jokes Sanders.


Up until 2007, if a homeowner were asked why he didn't hedge his house price risk, he might have answered, "Why, my house has done nothing but double or triple in price over the last six years. Why on earth would I have wanted to hedge?" Now, Sanders suggests some institutions are coming around to the thought that maybe homeowners should hedge, the biggest reason being that for the majority of U.S. households the home is the single largest asset in the portfolio.


Who else would want to hedge? Financial institutions could benefit because they have billions of dollars in mortgage liabilities on balance sheets. Why not homebuilders? They have clearly bet on the future, acquiring vast tracks of land for eventual development, or have committed in a big way to one region, such as Florida, only to see investments go south.


The way to hedge the risk of house price declines is with Chicago Mercantile Exchange (CME) Housing Futures, which is based on the S&P/Case-Shiller Home Price Indexes. CME Housing Futures and Options would be settled in cash to a weighted composite index of U.S. real estate prices, as well as to specific markets in 10 major U.S. Cities (Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York, San Diego, San Francisco and Washington, D.C.). The indexes are based on recorded changes in home values, using a methodology called the repeat sales pricing technique.


"In terms of deliverable contracts, what one can do is actually set up a localized futures market for properties," says Sanders. "This would free up a lot of homebuilders to weather the storm better and make homebuilding markets more efficient."



Bottom Line:


  • Since the turn of the millennium, real estate has become one of the fastest growing investment sectors, not just in the United States but globally as well.
  • Considerable risk is involved in real estate investing and one of the ways to ameliorate that risk is through hedging practices.
  • Real estate derivative markets -- the lynchpins for hedging -- are almost here, with a number of indices either in the development or planning stages.