Some of the anxiety of potential homeowners who continue to sit on the sideline, either waiting for home prices and/or interest rates to fall, is that there's nothing they can do. The performance of the CME Case Shiller home price futures over the last four years illustrates what they could have achieved by hedging from the long side. Again, I'm not saying that one should extrapolate into the future. Past performance is no guarantee of what the futures holds. However, if potential homebuyers (or those looking to move from one region to another) are worried about prices "getting away from them" read the rest.
The graph below shows the ratio of closing prices of each of the 11 CME Feb 2024 (G24) contracts from Feb 2020 until Friday Feb 23rd. ^1 The table at the top shows both the year-on-year percent change in the close as well as the gains over the four-year period. Note that these gains are on the contract price. In most cases FCMs (futures merchants) offer margins of < 10%, so gains using leverage would have been much higher. ^2 ^3
While closing prices tended to move together into early 2021 ^4, by mid-2021 prices began to vary as traders began to infer different impacts from Covid. (Note SFR and WDC became the relatively worst performers, consistent with relatively poorer success in return-to-work (RTO) policies, a possible early indicator of CRE problems in those metros).
That said, the (unleveraged) gains across all 11 regions for the four years ranged from ~22% to ~ 64%, with the benchmark 10-city index contract gaining 37%. A future homeowner, looking to eventually buy a home, could have profitably hedged the risk of prices getting away to the upside, in buying any of these contracts at selected points in time.
As importantly, while the Rent v Buy is a binary decision, a long hedger could've employed a dollar-cost averaging strategy (buying one CME contract lot at a time) to avoid picking an intermediate top.^5 In effect the forward purchase could be hedged over many months, quarters, or even years. (See my 2019 blog for more details on this approach: https://www.homepricefutures.com/posts/reduce-the-stress-of-100-rent-vs-100-buy-decision-with-bite-sized-pieces)^6
Alternatively, instead of a future homebuyer being 'short" the market by $375,000 (in this case short means their actual exposure $0 versus their target exposure of $375.0000, they might consider partial hedging. For example, someone owning $150,000 notional exposure to home prices via CME futures, may be still be hurt if all prices keep rising, but the gains on their hedge will partially offset that pain. On the other hand, if all prices fall, they will get to buy the house they wanted at a lower price, but that benefit will be partially offset by the loss on the futures. Net, a partial hedge should have less risk to wider price moves.^6
The discussion above directly applies to the metros reference by CME Case Shiller futures contracts, but similar hedging strategies can be created in OTC (over-the-counter) hedges on any of the top 50 metros. Feel free to contact me if you'd like to see a hedging strategy on a particular metro, or if you have any questions about this blog.
Thanks, John
^1 Ten regional contracts and the 10-city index contract.
^2 Of course with leverage the risk to downside moves is also more pronounced.
^3 A risk, that somewhat explains the dip in prices in Feb-April 2020 (beyond Covid) is that an FCM can (and did) raise margin requirements dramatically. In winter 2020 one FCM raised margins to ~100% of notional value, prompting many users to close positions.
^4 This may have been due to a greater use of pricing of the 3-4 year forward contracts with intercity spreads, as opposed to calendar spreads, or the lack of any outright third-party inquiries.
^5 As a hypothetical example, since each contract has notional value of $250 *price, at a price of 300, a contract would have notional value of $75,000. Someone looking to buy a home for $375,000 could've hedged that risk by staggering the purchase of 5 lots.
^6 These are all hypothetical examples. There is basis risk (the risk that prices of the house, the neighborhood or metro, move differently from these, or other OTC contracts.)
#realestate, #homeprices, #hedging