One of the three most common pushbacks I get from readers when they ask about the CME Case Shiller futures (and other home price index derivatives) is that they don't want to buy forward prices that have gains priced in, but would rather buy a derivative on the spot index, and then ride it up "should" home prices increase.^1
Because I hear this so often, because it's fundamental to understanding the futures, and now because of some interesting work being done in monetizing current home equity exposures, I'd like to walk through a number of reactions.
First, I'm not aware of any spot derivative exposure on Case Shiller indices, nor would I expect to see one, as if it did exist, one could buy the spot contract, finance it at a low rate (e.g. 3%), sell the one-year forward contract at the market price (+10% in the case of San Diego) and pocket the difference. If you see a product (e.g. a total rate of return swap) that tracks spot home price indices, grab it, particularly during the seasonal winter lows, sell the offsetting future, and ride to the bank.
Unlike stocks, bonds, Foreign Exchange (and even the emissions contracts in which I make markets), the Case Shiller index falls into a category of exposures that don't lend themselves to buy/finance/carry and deliver/. For example, at one extreme, one can't carry economic indicators (e.g. unemployment), weather, and (today) electricity, so those spot indices can diverge from futures.
Case Shiller futures fall between the two ends of cash-and-carry extremes. Someone owning the entire universe of homes backing a Case Shiller index might (in theory) be able to do such a trade (ignoring the impact on society of buying/selling every eligible home), but not someone owning just a number of houses. One such problem that the composition of the market might change a year or two from now. For example, the seasonality of homes in the colder northern cities of Chicago and Detroit had much larger price swings (and swings in non-seasonally adjusted prices) as the composition of distressed sales rose in the winters of 2008-2010. ^2 ^3 You'd need to have exposure to a very large number of homes that were highly correlated with the indices, and traded at low cost. (See below).
Second, even if forward quotes have some element of expectations baked in (and I would push back on this for longer-dated contracts^4), they still provide the opportunity for users to hedge^5. That is, there may be two groups of people looking to buy (or sell) a property in Washington DC a year from now. For example, a future buyer might be a Millennial looking to work there after finishing an advanced degree, while a seller might be someone looing to retire to Florida or Phoenix. Note that their housing needs might differ. The new buyer might desire a downtown condo, while the seller might be looking to sell their 4-bedroom house. Since both are in DC (in theory) both are correlated with the WDC Case Shiller home price index.^6
Both parties might agree that DC prices will be 10% higher a year from now, but both have the risk of being wrong. Sure, if prices fall the prospective buyer benefits, and if prices rise the future seller benefits, but the opposite results hurt each.^7 The parties have uncertainty which they might try to address by buying (in the case of the forward buyer), or selling WDC contracts even at +10% to spot. Note that each can opt to hedge as much as they want (as they will have different future exposures and different tolerances to risk) as the contracts come in bite-sized pieces ^8 Since the contracts come in smaller sizes (than the home price) they can also spread out the buying decision over months if they want to avoid the risk of concentrating their decision into one date. (see Benefit of Bite Sized Pieces). My role is to provide bids for those looking to sell, when they want to sell, and offers to those looking to buy, when they want to buy. While matching two offsetting positions (for the same amount, the same expiration and on the same date) might be a textbook example, it is highly unlikely in practice, but I stand ready to bid/offer as flow evolves.
Net, both parties have the risk that prices can diverge from consensus and both can try to reduce risk (uncertainty) by hedging, even if the clearing level is +10% over spot.
Third, while there has been no tradeable spot index, there are a number of entities that are looking to create spot-like exposures. This is a fascinating current topic as, ten years after the bottom in home prices, homeowner equity has grown to $23 trillion. Much of this is likely concentrated in older homeowners who had the means and opportunity to buy at much lower prices than today. That audience might be need the funds for other uses (e.g. underfunded retirement plans) or may want to get ahead of estate planning. (Think home equity lines that take appreciation rather than coupon as reward, new-issue reverse mortgages, or evolving forms of co-homeownership where equity is shared between the homebuyer and institutional third parties.)
A business that can tap even 1% of this market, might create $230 billion of product that should bear some resemblance to spot indices.
Further, institutional investors have had few ways to gain exposure to spot home prices (and further prices by targeted regions), instead relying on REITS and BTR (buy-to-rent) programs that tend to have more diversified geographic exposure to (often) lower-priced homes. ^9 I've had many "kick the tires" on Case Shiller futures, but have backed off waiting for more volume. This monetization of equity could be their chance.
Net, conversations about products that have exposure to spot home prices, and discussions about where home prices are headed, may become even more heated as institutions are presented with investment opportunities. As such, my hope is that the CME Case Shiller futures markets (and other derivatives) may start to see ever more inquiries into the shape of forward curves, and hedging/arbitrage strategies.
I'm eager to stay on top of all such discussions, so please feel free to contact me to weigh in on any developments and/or your thoughts on how creating such a large spot market in home equity exposure might impact hedging strategies.
I am in discussions with several entities involved in new programs, and would like to be able to steer readers of this blog to different programs (both from the investor and home price hedging sides) Please DM to discuss.
Thanks, John
Footnotes:
^1 the two other most popular pushbacks are a) lack of volume, and b) basis risk for someone looking to hedge their individual home.
^2 Distressed houses often sold for 30% discounts. If 20% of the sales during the winter (when houses had snow-covered yards) cleared at 30% discounts, the index would be pulled down 6% by distressed sales. See "Be cautious when reviewing SA numbers"
^3 BTW-those distortions stayed in non-seasonal to seasonal adjustments for years.
^4 See - (looking for past blog)....
^5 Similarly to people who might have exposure to changes in weather or who want to lock in forward electricity costs, regardless of today's weather or spot electricity costs.
^6 Understanding the degree of correlation and any beta between the two housing sub-sectors is important when hedging. (See Footnote 1 above)
^7 BTW - If both parties sell at +10% and the index settles at +10%, then neither lost money in the hedge (but both may have slept better in the intervening year).
^8 One lot has notional value of $250 *Price (~310 for WDC Feb '23) or $77, 500 per lot.
^9 REITS may also be more focused on investors interested in income plays, not price appreciation.