Options for real estate hedging

In 2008, a bank liquidity crisis was touched off by toxic mortgage products. Unqualified borrowers were securing mortgages that were later bundled and securitized. That and the low interest rates led real estate prices to skyrocket. When that bubble burst there was a run on the banks. Many homeowner mortgages were under water and they simply walked away from their homes. The Great Recession ensued and we are still feeling its effects.

As an antidote, the Fed kept interest rates artificially low, which pushed investment into risk assets, mainly stocks. The Fed also engaged in numerous rounds of quantitative easing, buying large amounts of mortgage-backed securities and Treasuries. Fed Chair Janet Yellen has recently stated that the Fed will begin trimming the resultant $4.5 trillion balance sheet from those purchases. Before the Great Recession, it stood at $1 trillion.

If there is another real estate rout, homeowners don’t have to be helpless bystanders. The iShares US Real Estate ETF (IYR) tracks the results of the Dow Jones Real Estate Index, which tracks the results of real estate investment trusts (REITs) and companies that invest either directly or indirectly in real estate. Property values across the country vary widely, however, when a bubble bursts all forms of real estate correlate very closely.

On Jan. 1, 2007, IYR was at its highest level ever, $91.40. By Feb. 1, 2009, IYR was trading at $25.14, a 72% decrease in 25 months. On July 1, 2016, IYR had gotten back to $85.40 (see “Bust & boom”).

IYR averages volume of more than six million shares a day. The Oct. 20 options expiration for IYR has 13 strikes that exceed 1,000 in open interest. The bid/ask spread for most of the options is 0.05; IYR is liquid.

The premium level for the out-of-the-money puts is four times that of the out-of-the-money calls. The IYR travels more rapidly to the downside than the upside.

Take a homeowner with a $400,000 home who wants to protect against a 25% decline in value. You can buy the IYR March 70-60 put vertical for 53¢. Your maximum loss on the spread is $53 and the maximum profit is $947.  If you trade the spread 100 times, you’ll make $94,700 on a 25% correction. The $5,300 is a hefty insurance premium for something that’s $9 out-of-the-money.

Another spread a homeowner can employ would be selling one March 75 put at $1.55 and buying two 70 puts at 74¢ in the same expiration cycle. That would provide you with a credit of 7¢ for each time you established the spread. If you established the spread 200X100 you would receive a credit of $700 for any price above $75 at expiration, while losing $50,000 at 70 and making $50,000 at 60. Those are all outcomes at expiration. Since you are buying two puts for every one that you sell, you benefit from a pop in implied volatility. At expiration, 70 would be a disaster but if it moved there in the next month it would be profitable because the 17% implied volatility might move up to 40%. You could net $20,000. Eventually, time value will erode and pops in implied volatility would have a lesser impact. You would need to get out of the position by February. You could perhaps employ some combination of the two spreads.

The steady increase in the IYR since 2009 — as opposed to its dramatic rise prior to the credit crisis and precipitous fall during it — indicates the real estate market is on steady footing, but it is good to have a way to hedge exposure to another major decline in home values.