Phoenix has been one of the hottest markets for home prices over the last few years. Great weather, increasing population, and good job prospects have all resulted in expectations of strong future price gains. How though, can a current Phoenix homeowner participate in that bullishness without buying a second home (paying broker fees, getting a mortgage, finding tenants, etc.)? How might they "bank" some of the gains that the market is expecting, without selling their home, or a permanent share of their equity, even if only on paper profits?
Similarly, how might a future buyer in Phoenix protect against home prices running up even further than some current expectations?
One idea worth considering for each is calls on the Phoenix Case Shiller NSA (non-seasonally adjusted) home price index. The current index (released in January) is 225.68, and I'd make a market 9x11 (i.e. bid side of 9.0 points/ offered side of 11.0 points) in 225 calls. Expiration would be Aug 31st, and all agreements would settle on the Phoenix NSA index announced that date (Case Shiller #'s are updated monthly on the last Tuesday of every month). All agreements would be done on my HPHF platform. As with other HPHF agreements, the calls would have a cap at an index of 245 to limit risk and to help collateralize all agreements. As such, the maximum payout across all price ranges would be 20 points (the 245 cap less the 225 strike). The options can't be exercised before expiration, and all options would be automatically exercised at expiration on the numbers released in August.
A call buyer would pay 11.0 points and therefore would break-even if the PHX index settled above 236.0 (or 4.57% above spot levels).
A call writer would, as in similar HPHF agreements, actually be buying a put at 245 for 11.0 points (i.e. selling to the bid side of the call market) with a floor of 225. Her breakeven would be at any price below 234 (245 minus the 11.0 point premium).
Premium prices are subject to change for a variety of reasons to include imbalance of buyers and sellers, changes in expectations, and time to expiration. My hope is to update premium quotes as agreements are done, to balance buy and sell interest.
Points could be negotiated per agreement. For instance a $100/point agreement (the minimum) would be consistent with a notional value of coverage of ~$22,500 ($100 * current index).
A benefit to such a strategy is that a homeowner who writes a call, and then sees that the index has risen to 234, will have their 11 points returned, while living in an area where home prices have risen. If the home price index is unchanged (so = 225 for rounding), then they will receive 20 points back in early September, and home prices in their region will not have declined. A risk of call writing strategies is that prices rise above breakeven, in which case the call writer (long put) will lose some portion of the 11 points they paid (all if the index settles > 245). However, in that case, Phoenix home prices will have risen by 8.5% (in 6 months). in addition, these agreements are capped at index values of 245.
One key to a writer's evaluation of their risk is how well they believe the price of their home will correlate with the Case Shiller Phoenix NSA index. (Recall that these are index agreements, so the characteristics of an individual house, and/or your intentions as to when you'd like to buy, or sell, are not factors in premiums charged.) Clearly some houses will do better than average, and some worse. The amounts of any paper gains in the value of one's house will depend on many factors.
A second risk to review, is how much notional exposure an owner might want to hedge. An advantage of derivatives is that they can be done in bite-sized pieces (See my May 17, 2019 blog on bite-size pieces for further thoughts). As noted above, the minimum size agreement would be for the equivalent of ~$22,500 in notional exposure. Homeowners then might be more comfortable hedging only a portion of the value of their home.
Similarly, someone looking to buy might consider hedging a portion of their future home's value. That way if index values rise above breakeven, they'd had some benefit, while if index values are unchanged (or fall) they might get a chance to buy the house of their dreams at a better than expected price.
In both cases, a key attribute to this program is that users will know the maximum amount at risk (the premium).
As to liquidity, I'm obligated to state that there is no guarantee that there will be any opportunities to unwind before expiration, but it is my intent to try and provide some.
Note that this program should work for any other city, but given the bullish outlook so many real estate forecasters have for Phoenix, it's likely that either premiums, and/or break-evens, will be lower.
Please feel free to contact me if you have any questions about this blog, the call program I've described, if you'd like to pursue a hedge, or if you'd just like to learn more about how home price derivatives can be used in hedging strategies.
Thanks, John