With the news of a vaccine from Pfizer, there's been a pronounced reallocation from the stay-at-home stocks (e.g. ZM, AMZN, NLFX, TDOC) to stocks that may perform better in post-vaccine, post-Covid world. Might this "reversal" also (eventually) apply to home prices?
Some forecasters (e,g. Black Knight) have recently written about how home prices have outperformed condos since January. I'm going to propose a template here for an HPHF agreement where one can express whether that view will continue, or lapse.
I would first note, that my proposal will use Case Shiller indices. There are many other more detailed and localized indices and databases (see Miller Samuel website for detailed info on the NYC markets) and I'm open to a proposal on another index, but for this illustration, I'll focus on Case Shiller (as among other things, there's a futures market for the NYM CS index).
There are five public Case Shiller condo indices that cover the same Los Angeles, San Francisco, Chicago, Boston and New York regions as the regional home price indices. The performance of the regional Case Shiller condo indices were highly correlated to the Case Shiller home price indices for the first four regions during 2012-2018. (Email to see graphs). However, the NY condo index had only a weak correlation to the NY home price index. While both indices cover the same counties, my working theory (for this trade, and to explain the lack of correlation) is that while condos might be either a smaller feature of the first four cities (such that condos are more randomly distributed across the defined Case Shiller areas), that for the NYM area, condos are more concentrated in New York City. As such, the NYM Condo index vs NYM "Aggregate" index might be a way of measuring the flight to the suburbs.
While the preference for suburbia has been touted as a recent (COVID-related?) trend, the performance of the NYM Aggregate index has been out-performing that of condos since late 2017. (I leave it to others to suggest why, but the role of Millennials, and relative strength of higher-priced homes -which might skew the results of comparisons using median prices - comes to mind).
While there is a NYM CME contract, and (in theory) one could enter an agreement on the outright performance of the NYXRC (Condo) index, for purposes of the city vs suburbs debate, the ratio of one index to another, might be a cleaner, less-risky way to express relative performance views. (Of course, with a public market for NYM contracts and the ratio bid and ask in hand, one could derive forward prices for an agreement on NY Condos. However, one would need wider ranges on possible results for an outright quote, and the boundaries might need to change from one trade to another. Ratio agreements address these two conditions, thus making the agreements potentially more fungible, avoid the issue of having to overcome two bid/ask spreads -one on the ratio and the second on the CME NYM market - and capital-friendly.)
The graph below shows the historical ratio of the CS NYM home price index vs the CS NY Condo index. Consistent with the graph above, as the home price index has outperformed the condo index, the ratio of the condo/home price index has fallen. I've highlighted year-end value in larger squares. At the far right, I've posted suggested bid and ask levels on the ratio (1.29 vs 1.31) referencing the year-end 2021 indices (so the Feb' 22 release). As the current ratio is 1.331, the quoted levels are consistent with the NY Aggregate home price level outperforming the NY Condo index over the next 15 months. For example, a 2.5% decline in the condo index, combined with the home price index being unchanged, would reduce the Condo/Home Price ratio to 1.298.
I'd be open to entering an HPHF Agreement at these levels with boundaries of 1.20 and 1.40. (Better still would be to match potential longs and shorts, so please weigh in with any interest).
To recall, a long would be structured as the purchase of a 1.20 call (with a 1.40 cap) for 0.11 (using 1.31 offer). The offsetting position to that would be the purchase of a 1.40 put (with a 1.20 floor) for 0.11 points (using a 1.20 bid). The combination would fully collateralize any potential payouts.
"Points" could be converted into levels that reflect the notional value of an agreement. For example, on a $130,000 notional agreement, each point could be designated to be worth $1,000.
While this example was presented to illustrate an agreement between NY Condos and Homes, the methodology could be applied to any two areas (e.g. a particular city vs a national index.)
Feel free to contact me if you have questions about this blog, have issues related to ratio trades, or would just like to discuss the notion of using home price index derivatives to hedge home price risk (long or short).
Thanks, John