Any investment you make is subject to market risk – the risk that the entire market for assets like the one you hold will go down in value – and real estate investing is no exception. The other truism is that anyone who owns a home is a bit of a real estate investor themselves so they are also subject to the vagaries of the real estate market. So, what if you could protect yourself from this market risk?
It turns out that there really is a way to protect yourself from the overall risk that Chicago area real estate values will go down using an exchange traded financial instrument. Interestingly, I was notified a couple of days ago that one Chicago real estate investor just took advantage of this to protect about $580,000 worth of real estate from a big drop in prices. Of course, he had to pay for this protection – $9,000 or about 1.5% of the value of his investment.
Here is how this transaction works. As readers of this blog know, the Case Shiller home price index for Chicago tracks overall home prices in the area. It’s just an index that is artificially set at a value of 100 for January 2000 and the most recent value, released in April for February, was 128.77. All that means is that for the 3 months ending in February, on average, home prices in the Chicago area were 28.77% higher than they were for the 3 months ending in January 2000. Yeah, that’s really not that much appreciation over the course of 16 years.
So what this real estate investor did was purchase an instrument (I’ll explain this instrument below for those that want the gory details) that basically pays him off if the value of the Case Shiller Chicago index is below 120 for the three month period ending in June 2017. For every point the index ends up below 120 in this time frame this investor will get $4500.
Basically, this investor is uncovered for the first 6.8% decline from today’s prices but this insurance contract kicks in to cover any market losses beyond that. In addition, I should point out that the “market” expects the index to actually be somewhere around 135 in this time frame so going below 120 is a bit of a stretch but if you are worried about it happening this is how you protect against it. I should also point out that this strategy only covers this investor for the risk that the Chicago area real estate market declines. It does not cover him for the risk that his particular neighborhood declines or that his property declines in value due to mismanagement or any inability to find a suitable buyer in the future or that he overpaid for the property to begin with.
Now, those of you who don’t have a stomach for such things can stop reading this post while I go on to explain a bit more of the details of this transaction.
The Case Shiller Home Price Index Futures And Options Markets
In previous posts I’ve mentioned that there is a futures market for the Case Shiller home price indices. As with all other futures contracts you can enter into a contract to receive or pay, at some point in the future, the difference between an agreed upon value of that contract today and the final value of that contract on that date in the future. The Case Shiller Chicago home price index futures contract for August 2017 is based upon the value of the index that will be released in August and pertains to the three months ending in June 2017. That contract seems to currently have a value of around 135, which is the number I referenced above as what the market thinks the index will be at that point in time.
What I have not mentioned before is that you can also buy and sell options on those futures contracts and that’s what our Chicago real estate investor did. He bought what are called PUT options, which basically entitle him to a $4500 cash payment for every point that futures contract ends up below 120. The term PUT normally means that you get to force the counter-party to your option contract to buy the underlying security from you at an agreed upon price – called the STRIKE price, which in this case is 120. Normally, if the price of the underlying security is below the strike price the owner of the put option would buy the underlying security at the lower price and then force his counter-party to take it from him at the higher price they agreed to. In this case there really is nothing to buy or sell so the two parties just exchange cash to settle the difference. Yeah, it’s kinda like placing a bet but it’s legal and can be done on the Internet.
Here is the original post from John Dolan that reports on this transaction with this Chicago real estate investor: First Case Shiller Option Trade On Futures Contract For 2016.
Gary Lucido is the President of Lucid Realty, the Chicago area’s full service discount real estate brokerage. If you want to keep up to date on the Chicago real estate market, get an insider’s view of the seamy underbelly of the real estate industry, or you just think he’s the next Kurt Vonnegut you can Subscribe to Getting Real by Email using the form below. Please be sure to verify your email address when you receive the verification notice.