Strategies for Hedging Residential Real Estate

by Brad Ferris on March 12, 2012

Stock Analysis Mailing List member Eric asks,

I read your recent article about the state of the Canadian housing market. I agree that we are in bubble territory and due for a correction. However, as a homeowner (in the Vancouver area no less!) how can I take advantage of this or at least protect myself from the downside? I guess the obvious solution is to sell my house and rent while waiting for prices to decline, but this is less practical when you take into account a family with 2 young kids, plus a house full of stuff that would need storage, plus the basement suite that brings in rental income, plus the fact that we actually like our house. Are there any other options? How would you hedge exposure to the Vancouver real estate market?”

Real Estate Hedging Strategies

Futures & Derivatives

Back in 2006 the Chicago Mercantile Exchange (CME) began trading futures contracts for the S&P/Case Schiller Home Price Index for residential and commercial real estate in the USA. To my knowledge these futures contracts are US specific only and investors cannot gain exposure to Canadian home prices which doesn’t make these realistic for an individual Canadian retail investor.

There are a huge numbers of derivative instruments used by financial institutions (Canadian Banks) to hedge against risks in real estate valuations. These will not be a good choice for two reasons; a lack of transparency and access to them will be limited by the available capital of a retail investor (these run in the millions of dollars).  So using these to hedge your real estate exposure is likely not a good idea.

Shorting Real Estate Investment Trusts (REITs)

Real estate investment trusts are excellent investment vehicles to gain access to various real estate markets and properties across Canada. Shorting a REIT (to protect against residential prices) won’t work well because a REIT’s assets are rarely regional; they have properties across Canada. Rents generally are locked into multiyear contracts protecting the REIT from short-term volatility. Another reason is that if housing declines significantly rents could be unaffected leaving the cashflow of any specific REIT unchanged and their valuation stable.

An investor could try to hedge by shorting a REIT ETF such as XRE (iShares S&P/TSX Capped REIT Index Fund) but with such an overwhelming exposure to commercial real estate it wouldn’t be something I would specifically attempt or encourage.

One thought would be that if an investor was extremely bearish on how any real estate decline could affect the Canadian economy at large (or the financials) in Canada both HIX (BetaPro S&P/TSX 60 Inverse ETF) or HIF (BetaPro S&P/TSX Capped Financials Inverse ETF) could be something to look at as shorter term investments to use during market volatility.

Pay Off Your Mortgage/Extra Mortgage Payments

I’ve already addressed the topic of extra mortgage payments this year, but if you could owe less on your mortgage and can potentially pay off your mortgage quicker than any residential real estate market volatility in the short-term won’t have as much of an impact.

For people who only put 5-10% down on their home and experience a 20% drop in the market will find themselves underwater very quickly bringing them to negative equity position. If an investor was worried the markets may drop soon in any significant amount I would encourage those who own less than 20% of their house to consider paying more off more of your mortgage as a superior hedging strategy for residential real estate. This not only improves your personal finances but avoids the scenario where you owe the bank more than you borrowed should you need to sell in a poor market.

In Eric’s specific situation though there are three important factors to consider:

  1. He has a residential property
  2. He lives in the Vancouver region
  3. He receive income from property

Residential home prices will be impacted more severely than commercial real estate and we know that Vancouver is likely to be one area where this will have a more significant impact when prices do correct.

Eric is receiving income from the property (bonus) and acknowledges that his family like their home and moving would be disruptive.

If Eric is expecting to live in his home for the next 5-10 years and can wait through any market volatility I would think that there is a compelling argument for him to simply focus on paying off a large chunk of his mortgage from personal savings and rental income avoiding the need to worry about where home prices may move in the next few years.
The market value of his home should only be a concern should he expect to move in the short-term (under 5 years) or if his equity in the home is less than 20% of the home’s current value.

What are your hedging strategies for real estate?

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