An alternative to “Fractional Interests”? (Package of CME Case Shiller Futures and T-Notes).

A number of fractional interest (“FI”)/ shared appreciation programs/ have been gathering steam (and funding) based on the assumptions of modest home price gains, paired with leverage (in the form of a homeowner’s mortgage).  The back-of-a napkin illustration is that should a home with an 80 LTV rise in price by 3% per year, the equity will rise in value by 15%.  An FI investor receives no cash flows (other than when the house is sold) but typically has no obligation for any expenses (e.g. mortgage payment, real estate taxes, home insurance, broker fees.)^1  (See footnotes at bottom of blog).   Since over the long-term, home prices might rise with rents, income and GDP,  the FI assumptions have merit.   I think that this is a great financial concept that could allow homeowners to have better access to buying (or to remaining in) the house of their dreams with reduced exposure to home price.   In addition, buyers of FIs can use this concept to gain exposure to the spot home price market wherever they want. ^2

However, the premise for gains is that home prices will rise by more than some amount.  Timing is important.  Forward markets for home prices, or in the following example, futures markets, may present an alternative opportunity.

For example, let’s say that you want to have generic home price exposure to the San Francisco market for the next four years.^3  An FI investor would have to pay the manager to find product to originate, ensure (or pay to ensure) that interest, taxes, and insurance are kept in force, and filter FI agreements to make sure that the homeowner can’t sell the home (at a slight loss) before the fourth year. Alternatively, (as shown below) one might create the same (or slightly better) cash flows using a combination of futures and Treasury notes.

On the left side of the table is a hypothetical investment in an FI.  I’ve shown the analysis as if the investment was in a $200k house (in SFR?!?!) but it could also be a share of a bigger house.  I’ve assumed that the price of the house mirrors the Case Shiller index over time.^5   As such, the house purchased for $200k when the index is 269.21, would change in value by the same percent as the change in the SFR index by Nov 2022. (see two left-most columns).  Leaving mortgage amount constant, the equity changes in value more dramatically.    That is, should the ending index value be 275, the equity would rise by $4,301, or 10.75%, over the four years.

To the right is a nearly similar exposure except taken with 3 CME Case Shiller SFRX22 futures (purchased at 275- the offering price yesterday).  While there is (of course) no gain if the contract settles at 275 in Nov 2022, the futures buyer will have the $40,000 to invest over the four years, that they didn’t have to use to pay the equity.^6  Assuming a 3% compounded return^7 on the $40,000, the cash would grow by $5,020, or 12.6%

Since both scenarios would result in someone holding about the same San Fran exposure,  the impact of changes in the index would be about the same.^8  The combination of futures and T-Notes out-performs in all shown scenarios. 

Net, while I’m a fan of FIs, there may be alternatives if a forward contract exists, and trades at an attractive rate relative to spot (i.e. we’re late in the home price cycle).

Anticipating a few nits:

  • The SFRX22 contract has had limited volume.  Each contract has notional value of ~$68,000.  An offer of one lot (at 275) may not present a viable business alternative.  That said, I expect more might be offered, or one might try to buy more contracts at a lower price.
  • The example I used has a home with 80 LTV.  Lower LTVs are also possible/allowed in FI programs, which might result in lower equity returns, thereby making the futures/T-Note combo more attractive.  (added after initial posting)
  • An prospective FI buyer looking for longer-dated exposure might be able to switch back and forth from FIs to this combination, and back again.  Most of the FI programs I’ve seen assume that FIs can be bought as homes are purchased.  There would be nothing stopping somebody from using this combination as a temporary parking place until they found the most attractive FI- to include up to Nov 2022.  In fact, if one believes that the SFRX22 are trading “too low” based on hedging needs, one might be able to unwind this trade, and reverse back into an FI in the future.  (As an FYI -in August traders were willing to pay 12.4 points to buy SFRX22/ sell SFRX18.  Today the SFRX22 is bid only 2.5 points higher than the Nov. 2018 spot index).
  • While FI programs may calculate an NAV, there may be no guarantee that an investor will be able to redeem at a discount, at NAV, or at a premium.  Today, there are public prices on the combination, and each part (the futures and T-Notes) can be traded.
  • I realize that there may be different tax treatment for an FI (long-term capital gain?) versus a strategy using futures (short term gains) and TNotes (interest income).  My point here is to illustrate that home price markets (i.e. FI’s and forward/futures markets) are connected.  Standard qualifier that you should consult with your accountant on any investment.  (Second update post original post).
  • Finally, while I’ve used SFRX22, this combination “strategy” might be an alternative for any index offered at level with gains (verus spot) of <3% through Nov 2022.  CHIX22 is quoted 98.4/104.0% so it might be possible to replicate this using the CHI index.  The HCI 10-city contract HCIX22 is quoted 101.7/103.4% so also close.  Finally, there may be other hedgers looking to short other indices (e.g. Greenwich, Ct., Dallas, Texas (see recent WSJ article) that might work in OTC trades.  I’d be happy to work with anyone looking to take exposure to such an FI-like combination in these, or other areas.

Feel free to contact me (johnhdolan@homepricefutures.com) if you have any questions on this blog, or any aspect of hedging home price index exposures.

Footnotes:

^1 Terms, including participation rates, and events allowing, or leading to unwind, are unique to each program, and may differ substantially.

^2 BTR (Buy-to-rent) programs (e.g. Invitation Homes) may be another way to gain exposure to home price risk, however the manager may already have concentrated exposure in geographic areas other than what a buyer would target.  FIs can be targeted to selected regions.

^3 I picked San Fran as it has both the flattest forward curve of the ten regional CME Case Shiller home price index futures, as well as because the SFR contracts have had the most activity.  Also, I’m using 4 years and the SFRX22 (Nov 2022) contract, but the same analysis might apply to the SFRX23 contract (when it starts to trade).  One might be able to even create longer expirations in an OTC trade, but those would require price discovery (as there is no exchange-traded product),  sellers at a level that works, and introduce counter-party risk.

^4 Recall that each region has 11 expirations, but a) the Nov contracts are quoted tighter, and b) making Nov vs. Nov comparisons dramatically reduces seasonal biases.  Also, there is a Nov 2023 contract, but no trades have yet occurred.

^5 Of course, an FI originator might claim that they only buy homes in above-average areas.  There may also be a debate as to whether new homebuyers (80 LTV) default at higher levels than those represented by a broad index, such as Case Shiller.  I’ll leave those points for others to argue. For now, this is just presented as an alternative for someone seeking generic home price index exposure.

^6 The futures positions requires margin but, for this example, the buyer might post the $40k T-Note.

^7 I’ve used 3% yields on T-Notes.  Those with a higher cost-of-capital might assign an even higher return to freeing up the $40k not spent on equity.  Further, since the yield curve is upward sloping the yield available for longer exposures (e.g. using SFRX23)  will be slightly higher.

^8 A key difference is that if home prices fall more than 20%, the FI holder will lose their entire equity, but no more, while the futures buyer would still be on the hook.

 

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