After writing the post Sell now, mortgage interest rates to keep rising, I received an email from John H. Dolan (firstname.lastname@example.org), Independent Market Maker –CME Case Shiller Futures & Options. He pointed out that sellers who are worried about potential declines in house prices don’t need to sell their homes. Instead, they can sell futures contracts (short the market) that will rise in value if the Case-Shiller index goes down.
In finance, a futures contract (more colloquially, futures) is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price or strike price) with delivery and payment occurring at a specified future date, the delivery date. The contracts are negotiated at a futures exchange, which acts as an intermediary between the two parties. The party agreeing to buy the underlying asset in the future, the “buyer” of the contract, is said to be “long”, and the party agreeing to sell the asset in the future, the “seller” of the contract, is said to be “short”. The terminology reflects the expectations of the parties—the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease in near future.
In many cases, the underlying asset to a futures contract may not be traditional commodities at all – that is, for financial futures the underlying item can be any financial instrument (also including currency, bonds, and stocks); they can be also based on intangible assets or referenced items, such as stock indexes and interest rates.
Hedging against house price declines
John Dolan is correct, if you short the proper number of futures contracts, you can negate the effects of price movement on your property, up or down. But therein lies the rub. Anyone who hedges their position losses any of the updside. It’s the main reason so few of these contracts ever get sold.
When Robert Shiller came up with the idea of a futures market based on his index, he envisioned conservative investors looking to hedge their real estate investments as a market for this product. Perhaps there are a few such investors out there, but most people aren’t willing to give up the benefits of appreciation for fear of prices going down.
Betting on house price appreciation
Perversely, if this index were more widely known, it would be used the opposite of the way it was intended. Most people, particularly the faithful here in California, buy houses because they believe the values will rise, and they want to profit from the appreciation. If you offered them the opportunity to hedge their bets, they would turn it down. A few of the more inquisitive buyers might as the logical follow up question: “Can I take the other side of that trade?”
In my opinion, if trading in this index became more popular, recent homeowners would buy up contracts in order to juice the profits on the appreciation they expected to see in their homes. Rather than hedge themselves against risk, most would blithely take on more risk. And since real estate always goes up (doesn’t it?), they would expect to hit the jackpot.
Further, investing in these futures would give homeowners a way to spend their equity like a HELOC abuser without taking on more debt. They simply have to sell a contract for a profit to turn appreciation into income. Some might even have the presence of mind to pay down their mortgage faster.
Don’t get me wrong. I believe buying for home price appreciation is a fools game, and magnifying that risk by buying futures is even more foolish, so don’t go buy up Case-Shiller futures because you think I am endorsing it as a good idea.
Renters can do this too
One of the main reasons people buy homes is because they want to profit on appreciation. Some people will even pay a hefty premium over the cost of a comparable rental to capture this appreciation. Of course, this is foolish because the profits get eaten up by the additional monthly costs (it’s even worse on the ROI calculation that looks at the timing of cashflows). However, most people don’t realize they can profit from home price appreciation without owning a house. That’s where Case-Shiller futures contracts come in.
Futures contracts are highly leveraged. If they didn’t move much, traders wouldn’t be interested in them, so the futures exchanges adjust the leverage ratio to make small movements in the underlying index have outsized movements in the value of a futures contract. Therefore, investors in futures contracts can enjoy nearly the same leverage as a financed home buyer.
Buying these futures contracts could provide renters with the same opportunity to profit from appreciation in the resale home market without actually owning a home. They could plow their down payment into futures contracts instead of a property. In markets that demand a large premium for ownership, like much of Coastal California, this provides renters and opportunity to obtain much of the benefit of home ownership while simultaneously enjoying the renter’s subsidy provided by homeowners who make payments much larger than the rental income.
If more renters did this, the most inflated markets would be far less inflated because the lure of home price appreciation would not motivate near as much buying.
As I stated previously, I don’t recommend buying Case-Shiller futures, but I do want to point out that there is a little-known mechanism for renters to benefit from home price appreciation as much as owners do.
If you are interested in futures on the movement of housing markets, you can reach John H Dolan, Independent Market Maker –CME Case Shiller Futures & Options at:917-562-0311 Johnhdolan@homepricefutures.
Why didn’t she sell it?
When I find properties that went into foreclosure that shouldn’t have — which I define as any property worth more than its original purchase price — then I investigate to see the cause. Ninety percent of the time or more, it’s because the former owner was a Ponzi who blew their appreciation on trinkets.
However, today’s featured property only had $400,000 in debt on it. The former owner did extract some cash, but not that much. When it went into foreclosure last year, the owner still had equity. She could have sold the property and collected a check for her equity. Instead, she let it lapse into foreclosure, and now ABM Investments, Inc. stands to profit from the sale.
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Proprietary OC Housing News home purchase analysis
6511 HALIFAX Dr Huntington Beach, CA 92647
$614,500 …….. Asking Price
$349,000 ………. Purchase Price
4/30/2002 ………. Purchase Date
$265,500 ………. Gross Gain (Loss)
($49,160) ………… Commissions and Costs at 8%
$216,340 ………. Net Gain (Loss)
76.1% ………. Gross Percent Change
62.0% ………. Net Percent Change
5.1% ………… Annual Appreciation
Cost of Home Ownership
$614,500 …….. Asking Price
$122,900 ………… 20% Down Conventional
4.40% …………. Mortgage Interest Rate
30 ……………… Number of Years
$491,600 …….. Mortgage
$120,864 ………. Income Requirement
$2,462 ………… Monthly Mortgage Payment
$533 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$128 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$3,122 ………. Monthly Cash Outlays
($487) ………. Tax Savings
($659) ………. Principal Amortization
$198 ………….. Opportunity Cost of Down Payment
$174 ………….. Maintenance and Replacement Reserves
$2,348 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$7,645 ………… Furnishing and Move-In Costs at 1% + $1,500
$7,645 ………… Closing Costs at 1% + $1,500
$4,916 ………… Interest Points at 1%
$122,900 ………… Down Payment
$143,106 ………. Total Cash Costs
$35,900 ………. Emergency Cash Reserves
$179,006 ………. Total Savings Needed