Experience in hedging RE investment via futures or puts?

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I would not recommend hedging for the time being. When we are involved with portfolio trading in stocks, we SOMETIMES use S&P futures to hedge PART of our positions. We do not use options as they are too expensive as explained above by Paul and the liquidity costs of them are too high for fast trading (we are not liquidity providers; we are takers). I am not interested in market neutral strategies. Most market neutral funds perform poorly. Only when the market risk is very high and the direction is least predictable, we fully hedge our positions under the assumption that we still have portfolio alpha; otherwise we will be out and sit on cash. For housing I don't see any systemic risk for the time being. If the market crashes again, you will see it at the time and then you may think about hedge if you can't sell. Financial hedge takes no time and you don't have to do it now.

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I happen to be a futures and options trader by trade for 25 years and a member of the CME. I am not a hedger at all though. I am a market maker. While it seems that ITB or case schiller might be the right market, I tend to think not, especially on a short term trade like 9 months. For one thing those are not active markets which means much more transactional cost getting in and out. In options there are also complicated variables like time decay and implied volatility that will effect the effectiveness of your hedge. Using futures would remove those issues. In my mind, the thing that might turn the housing market in the next 9 months would be a rise in interest rates. In addition, those are more active, liquid markets. I would use tbill or Eurodollar (not eurocurrency) futures to hedge this risk if you felt it necessary. TNote or Tbond would also work and bring a bit of inflation sensitivity into the mix. I personally would not bother with this. I know a lot of small builders and they have never felt this necessary. You need to really know what you are doing. There are lots of way to screw it up. If you are talking about 1 house....RE is local. Not all areas are going to react price wise in the same way, so there is no correct hedge for just 1 house or project. Hedging is usually done in a more macro sense. A large portfolio.

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Looking at ITB which trades @ $24.50. How many puts would you have to buy to cover every $100K of your project? Say you are worried about a 10% r/e decline ($10K or 4,100 etf shares). Your choice is July 2014 or Jan. 2015 expirations for your nine-month project. The July 25 Puts are $2.35 (cost you $9,600). - If ITB closes at $22 on July expiration your options are worth $3.00 ($12,300). You net only $2,700 and you are assuming your project is worth $10K less. Net loss $7300. - If ITB is at $25 your options are worthless costing you net loss $9,600. - if ITB is at $27 your options are worthless and hopefully your project is worth 10% more than expected (wash). Net break even. What about deeper in-the-money puts? Let's go up to July 28 puts at $4.35 ($17,835). - If ITB closes at $22 in July those puts would be worth $6 (24,600) netting you only $6765. Property woth $10K less. Net loss $3,235. - If ITB is still at $25 those puts are worth $3 (12,300) costing you $5,535. property still at @ $100k. Net loss $5,535. - If ITB closes at $27 (10% higher) they are worth $1 ($4100) costing you $13,735. Property worth $110k. Net loss $3,735. As you can see in my examples the cost of the insurance is expensive but deeper might be the way to go. The last scenario I can think of is a ratio: Sell 4,000 July 25 Calls for $1.85 ($7,400); Buy 4,900July 23 puts for 1.50 ($7,350) (costing you nothing) - If ITB closes at $22 in July those puts would be worth $1 ($4,900). Property worth $10k less. Net loss $5,100. -If ITB closes at $23-25 those puts & calls are worthless. - If ITB closes at $27 in July those calls would be worth $2 costing you $8K to buy back, however, your project is hopefully worth $10k more. Net gain $2K. - If ITB closes at $30 in July those calls would be worth $5 costing you $20K to buy back, however, your project is hopefully worth $20k more. We've also made some HUGE assumptions here incl. @4000 shares being adequate protection, that ITB will move in step with your r/e market, that you don't cover the options early, that July strikes are best way to go (Jan. 2015 might be better), etc. As you can see, the strikes you use will depend on where you think the market is likely to land. However, I think you have to assume market will stay about the same or go up; otherwise, why would you take on the project to begin with? In the end, I think its too expensive and presumptuous to offset market risk like this. You also cap/hinder upside which is the reason we do real estate, no?

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I think its an interesting topic. If you buy puts on a stock or ETF as a r/e hedge you are making the assumption that equities (more specifically the stock you own puts on) move in the same direction as the real estate market the home is in; This may or may not be the case. Also, one would have to buy so many puts to be hedged 1:1 that it could become cost prohibitive. I think the best hedge would be buying low enough to withstand a 10-15% r/e market decline.

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Thanks Eric, great perspective.

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Very good points, Paul. In particular, the "insurance" benefit of hedging does seem expensive especially when using ITB, because this ETF tracker of the home-building stocks is very volatile in price, which makes the options expensive. I'm told by someone who's done the analysis that it may be less expensive with either options on an ETF of REITs, or futures on the Case-Shiller home index sold on the Chicago Mercantile Exchange. I'm looking into those next.

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@Scott L. Though there are regional and national real estate markets and statistics, when it comes to actual properties, real estate is local. It is possible for the national index/etf/itb to be soring and the city/town in which you hold your properties just lost a major employer or vice-versa. For most real estate investors your best hedge is to buy your properties well - when performing diligence model the property with rent set under market, a sufficient allowance for vacancy & bad debt, and realistic to conservative operating expenses. If the property can still produce free cash-flow, or at lease carry itself, under your rainy day scenario, then you know the price to offer.

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Robert, I just saw your point, thank you. All feedback is good! For me, it seems to make sense and I would think for others in a similar position. As an investor, I'm only able to participate in one, maybe 2, refurb-or-build projects at a time (assuming I'm not a small cog in a big syndicated real estate deal). So that seems to fit the category of eggs in one basket, benefitng from hedging. I would think the same would apply to those holding many more rental units. If a concentrated location for your rentals goes south, they all will be impacted to some degree. The tough part for me as an investor would be to diversify my projects so much that I'm dealing with different types of real estate in different markets - too much ground and market knowledge to cover. Even then, real estate is prone to price bubbles across whole regions of the country, due to how the Fed sets interest rates and how REITs and stock are doing. It's hard to diversify that away. Thank you again, and I'll keep posting what I find. I believe options can be had for a few hundred bucks and go up from there, with modest training needed beyond stock buying online.

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Good points Paul about the type and size of hedge. For the investment vehicle to use, I was thinking of ITB which is the US Homebuilder's index ETF for house construction projects, and REZ, the residential equity (i.e. home rentals) REIT index ETF. While neither are specific to one MSA/location, and each have a bit of extra stuff in them (ITB includes a bit of home DIY store stocks), they should be directionally correct in case of a big downturn. You can buy options on these fairly easily. There's also buying futures on the Case Shiller index for any of 20 major housing metro markets; it purely measures changes in repeat-sale home prices, a proxy for refurb projects. For me, this would take a new options account at a specialist broker, but I'm calculating out the benefits of this "pure play" hedging index, vs the effort. As to the amount/cost of the hedge, I agree that you're mainly trying to avoid a loss if a market bubble hits or you're stuck with an unpurchased/unrented home for some time. Having said that, long-duration (6-12 month) put options, that are out of the money (the market would have to decline at least 5% for them to start generating positive $ returns) are not that expensive. I'm working on the calculations this week, but hopefully you can protect from a loss on a property you are targeting 12% - 20% profits on, for just the 'insurance price' of 1 to a few percentage points.

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I have to tell you @Scott L. I think this idea is way outside of the realm of the concerns for the average investor. A developer or large scale multi-family investor might have concerns that could be addressed by such a strategy, but I just don't see where the average investor who is conservative (buys smart/makes sensible profit projections) and diversified (not all the eggs in one basket) would need this kind of complex "hedge" for their investments. Your example is "a home" for a "sale close in 9 months" and that sounds like one big project and all of your eggs are in one basket.