What might it cost to hedge Seattle home price risk?

With Seattle being one of the strongest home price markets in the country, some homeowners might be worried about a retreat in prices.  Of course, they might prefer not to sell their homes, uproot their families, and move into a rental for both cost and logistical reasons, just to express a view on home prices.    While there are some products that offer a homeowner the ability to buy protection on the price of their own home (e.g. Value Insured), payouts on such policies , are often structured as insurance and typically require the sale of the house at a loss.  While they might be a better product for a longer-term perspective (and particularly if one is planning to leave the Seattle area when they sell), there may be better alternatives for those that want to stay in their house, and/or have a shorter term horizon.

I’d argue that a put option on a Seattle home price index might be an ideal product.   For those not familiar with financial products, a put gives the owner the right, but not the obligation, for a predetermined, negotiated fee (and no future payments), to sell something at a specified price (“strike”), on some particular item (“reference obligation”) either at some future time, or over some time period.   (Note that a put can be arranged for any time period, or for any strike.)  Puts exist on several financial exchanges for businesses to protect against the sale of key products they produce (e.g. wheat and oil).  Exchange-traded puts for home price indices were launched in 2006.    While puts sounds like (and act similar to) insurance, in that you pay a fee and are partially compensated if something bad happens, puts don’t require a loss on the sale of your house, to monetize a decline in home prices.  Also, unlike most insurance, you can trade the put to another person -although no market currently exists.

While no such exchange-traded product exists for Seattle, there are contracts on the other regions that can be traded on the CME (Chicago Mercantile Exchange).  I am the market maker on those contracts and so will borrow heavily from how those are structured to suggest a template for a Seattle product and what prices I’d quote.

The CME contracts reference the Case Shiller home price indices, so I’ll use the Case Shiller Seattle (NSA*) index here.  The CS indices are probably the oldest, most often cited example of a home price index.  They are updated every month on the last Tuesday by S&P.  This week the index for February was updated to 238.24.  Think of this as meaning that the value of houses has appreciated by 238% since Jan. 2000.   I am open to referencing another index (e.g FHFA or Zillow), or even a sub-section of the Seattle market e.g. an area clearly defined by zip code or neighborhood, but  since I will be making comparisons versus other Case Shiller contracts, for consistency, I will stick with the CS index (*and in particular with the non-seasonally adjusted index.) for this analysis.

The shorter CME contracts expire at quarterly intervals (on a Feb., May, Aug., Nov. cycle) so I’ll use May 2019 as the contract term here (as slightly more than one year).

Further, the CME contracts can be exercised only at expiration, which for May 2019 would be May 28th, 2019, so I’ll use that here (but am open to discussing a contract that could be exercised at any time, but pricing would be higher).

Finally, I’ve highlighted a series of quotes where I’d be open to offer puts on the Seattle CS index for strike prices ranging from 240 to 250 for May 2019.  I’ve denominated these quotes in terms of points versus the Case Shiller index, but also show how such price would be expressed in terms of the spot index.  That is, the premiums for one-year protection would range from 2.87-3.93%.  (Like car and home insurance one can either get more coverage, or reduce the upfront premium by changing the deductible -in this case the strike.)

So for example, the cost of protection to May 2019 on $100,000 of index value struck at 240 would be $2,870.

One additional consideration is that while puts (including CME -listed housing puts) can protect a buyer down to a price of zero, that leaves the put seller (often referred to as the “put writer”) open to catastrophic risks that are better insured by governments (think flood insurance).  As such, I’ve added a maximum payout (or a strike floor) to this exercise, similar to how I would approach put writing in the LAX (Los Angeles) and SFR (San Francisco) contracts, where an historic earthquake might crush home prices.  In this first example I’m using a floor index of 200, or about ~16% below today’s Case Shiller Seattle index.  That would imply a maximum payout, should the index in May 2019 print below 200.0 or~$16,700 on this $100,000 exposure.  (I can only imagine the financial disarray were that to happen.)

As illustrated below, the payout on such a put option would look like those for other products.  That is if the index settled above the strike value a put buyer would lose only their up-front premium, while for every point below the strike the intrinsic value of the put would go up 1:1.  (Puts may go up or down in value prior to expiration, so I’m only showing intrinsic value at expiration for ease of illustration).  (Note- I’ve scaled the graph to illustrate various payouts.  The graph is not centered on what i might considered the most likely scenario.)

I hope that this introduction of puts on the Seattle Case Shiller index serves to prompt discussion on expectations of index levels in the future, the produce structure I’ve outlined, and suggested offering levels.

Please feel free to contact me (johnhdolan@homepricefutures.com) if you’d like to discuss any aspect of this blog, or the topic of hedging home price risk.








One Comment

  1. IF plenty of volume can be generated – these can be used by Pulte and Toll Bros and other large National Merchant Builders who have millions committed to various markets. Or Blackrock with Billions in Rental Houses.

    If one believes in Inflation is and will be at a much higher rate than is promulgated by Washington (regardless of Party in Power) as I do – Puts don’t need to run forever or down to zero – they might
    intersect a trendline of Inflationary values in 12-18-24 months.

    As a recovering Builder back in the 70’s I realized that by buyers who held a house or condo we sold them, could and were re-selling the same property in 2-3-4 years and making more profit that we had developing it. So we arranged with some of our lenders to do “Mini-Perm” loans (30 yr amo due in 5) allowing us to lease the completed unit for 3 years and then sell it. We had paid $X for Conrete, and $Y for labor 3 years prior but we were competing for sales with new building that paid $X x 105% x 105% x 105%, and labor the same (ask any workman what he makes today and what he made 3 years ago). Inflation has saved the bacon of real estate developers, investors and lenders for 50 years. Sure Location, Location, Location, but Inflation, Inflation, Inflation is about as important. So if you can afford Puts out a year or two then inflation will protect you beyond that.

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