New Tools Available To Hedge Your Home

Amid warnings that real-estate values may drop, exotic investment products target anxious owners eager to lock in their gains.
By: James R. Hagerty: From The Wall Street Journal Online
Once, a home was a castle. Now it is looking more like Fort Knox - a pile of money in need of protection.

Amid warnings from economists that real-estate values in some parts of the country may drop eventually, there is a nascent movement to offer new investment products designed partly to hedge against falling property prices. The goal: Offer limited protection against the risk of riding real-estate prices back down again after the record run-up in recent years.

In recent months, Merrill Lynch & Co. and other investment banks have started offering investment products that will rise in value if a basket of housing-related stocks declines. Already, nearly $400 million of these investments have been sold, according to Daniel Carrigan, vice president for new-product development at the Philadelphia Stock Exchange.

The Chicago Mercantile Exchange also is preparing to announce plans to introduce in the second quarter of next year futures contracts based on home prices in each of 10 cities. It will also offer a composite contract covering all 10 cities. That plan follows the introduction last May by HedgeStreet Inc., based in San Mateo, Calif., of financial contracts called Hedgelets that let investors bet on a rise or a fall in home prices in six individual cities.

Strategies like these are far from foolproof, however. Derivative products like these can be complicated and risky, and none of them offers a perfect hedge against the risk that the value of any individual home will fall. But they do provide a new strategy for people worried about an eventual slump in housing.

For people who shy away from the complexities of derivatives, there are an array of other options for shielding home equity. These strategies range from the straightforward -- for example, locking in a fixed-rate mortgage while rates are still low -- to riskier approaches, including perhaps becoming a renter for a while.

The stakes are high for homeowners: In the past five years, home prices nationwide have jumped an average of 50%. That has bulked up the net worth of many Americans but also left a much larger proportion of their wealth locked up in real estate.

Since 1999, Americans' equity in their homes has soared 68%, to nearly $10 trillion in this year's first quarter, according to Federal Reserve data. During the same time, the value of stocks and mutual-fund shares held by households and nonprofit groups has declined 18% and also equals about $10 trillion.

Tom Atkin, a 58-year-old marketing consultant, nine years ago paid about $335,000 for a three-bedroom ranch house in the San Fernando Valley near Los Angeles. He figures it is now valued at well over $1 million, and has thought about selling his home now while the market is hot and moving to a less-expensive area. One problem, he says: "I wouldn't know where to put all the cash [from the sale] that would earn as good a return."

While many economists warn that prices in some regions eventually could level off or fall, the housing market has thrown off mixed signals in recent weeks. Inventories of unsold homes are up sharply in some areas, including Boston and the Virginia suburbs of Washington, suggesting that buyers have become more cautious and are taking their time. Another indicator of concern is that houses have become hard for most people to afford in some places. A new study by Carl Haacke, a consultant who was a White House economics aide in the Clinton administration, found that nearly a third of homeowners in Miami, for instance, are paying more than 40% of their incomes in housing costs.

Yet at the same time, there are optimistic signals. Applications for mortgages by prospective home buyers have rebounded in the past two weeks after slumping on a seasonally adjusted basis during most of the summer. And prices are continuing to rise steeply in much of the country, though that only adds to worries that any eventual decline might be more severe.

While it is impossible to protect yourself entirely from the possibility of a decline in home prices, there are strategies for shielding yourself against at least part of the risk. Here is a sampling:

Dabble in derivatives: There are a variety of ways to use the financial markets to provide a limited hedge against a weak housing market. All of them are far from perfect, and most would be too complicated or risky for the average homeowner.

Among the newest twists in this area are the housing-related notes recently offered by Merrill and other investment banks. Merrill's Protected Bear Notes, introduced this past spring, offer a way to bet on a decline over the next eight years in the Philadelphia exchange's Housing Sector index, which is based on the stock prices of 21 companies involved in home building or closely related businesses. The notes will gain in value if that index declines.

Several other firms, including Morgan Stanley and Royal Bank of Canada, have offered similar notes. ABN Amro Holding NV, the Dutch banking concern, has offered a version of these notes to investors outside the U.S.

While these notes offer a way to profit from a slump in the housing industry, they aren't an ideal hedge. House prices in certain areas could fall or rise based on such factors as the health of the local job market, regardless of how national home builders are performing.

The Chicago Mercantile Exchange is focusing more directly on house prices. It recently reached an agreement to launch housing futures contracts devised by Macro Securities Research LLC, Morristown, N.J. The owners of Macro include a Yale economics professor, Robert J. Shiller, who is known for his gloomy views on the housing market. The futures will be based on indexes of prices in 10 large U.S. metropolitan areas, says Sam Masucci, chief executive of Macro. "We believe there is tremendous interest from people who are interested in hedging home prices," he says.

HedgeStreet, whose Web site is www.hedgestreet.com, has a jump on the Chicago Merc. The firm offers its Hedgelets as a way to allow buyers to bet on a rise or a fall in home prices in Chicago, Los Angeles, Miami, New York, San Diego and San Francisco.

For instance, the site on a recent day offered the possibility of betting that the median San Diego home price at the end of the current quarter will be either above or below $643,000, compared with about $605,000 in the second quarter, as calculated by the National Association of Realtors. If a client correctly bet $1,000 that the third-quarter price will be lower than $643,000 when it is reported in mid-November, the Hedgelet would be valued at $1,140, or 14% more than the amount invested. However, if the price rose above $643,000, that Hedgelet would be worthless.

There is little trading in these contracts so far. Also, the contracts expire quarterly, so it is impossible to buy a long-term hedge. "It's small but growing steadily," says Russell Andersson, a vice president and co-founder of HedgeStreet.

Jonathan Reiss, a financial consultant in New York, says he has been experimenting with housing Hedgelets and has made some money by betting on a weaker market. Mr. Reiss, who owns a home in Manhattan, says the Hedgelet market is too illiquid to allow any real hedging.

Switch to a fixed-rate loan: Over the past few years, more Americans have been taking out adjustable-rate mortgages, which offer lower rates but expose borrowers to the risk that they will have to pay much higher rates later on. So far this year, around a third of all applications for home loans have involved adjustable rates, though that proportion has been falling in recent weeks.

Many financial planners say it is time to ditch those adjustables and lock into long-term fixed-rate loans, taking advantage of fixed rates of around 5.75%, very low by historical standards.

When the general level of interest rates goes up, so do payments on adjustable-rate loans. "You kind of put yourself in a vise if you have an adjustable-rate mortgage and you see your property value going down while your mortgage payments are going up," says Michael Maloon, a planner in San Ramon, Calif.

Even so, adjustable-rate loans are cheaper, at least in the short run, and can make sense for people who know they are going to move within a few years.

Make sure you have cash reserves or a credit line. Financial planners recommend that homeowners make sure they could keep paying their mortgage even if they lose their jobs or suddenly can't work for health reasons. "You need something between you and the equity in your house," says Phil Cook of Cook & Associates in Torrance, Calif.

That is vital because in a weak housing market you may need lots of time to find a buyer for your home. If you are unable to meet monthly payments, you would have the choice of defaulting (and destroying your credit rating) or slashing the price to fire-sale levels.

Having enough savings would let you keep paying the mortgage while waiting for a buyer. An alternative for those without much savings is to take out a home-equity line of credit now, says Charlie Fitzgerald, a financial planner in Maitland, Fla. That provides a standby loan that could be used temporarily to meet mortgage payments in a pinch.

Sell some property. People who own second homes or rental units might consider selling some of them while prices are high. Seok H. Jo, a financial planner in Los Angeles, says some wealthy clients are cashing out of rental properties and second homes, putting the money into municipal bonds or large-cap stocks instead.

Bill and Linda Cronin were so worried about the danger of a housing collapse that they recently sold their primary residence in Lake Helen, Fla. -- and moved into a recreational vehicle, which they are using to tour the U.S. Mr. Cronin, 58, a retired management consultant, figures the housing boom "is going to come to a screeching halt eventually."

Still, the Cronins have hedged against the risk that house prices will keep rising: They still own a rental home in New Smyrna Beach, Fla.

Another tactic: If you live in a frothy housing market and expect to move within a year or so, it may be worthwhile to consider selling now and renting for a few months. Last year Dean Baker, a Washington economist who is bearish on U.S. real-estate prices, decided to take profits on the two-bedroom condominium he and his wife owned in Washington's Adams Morgan neighborhood. Having bought the condo for about $160,000 in 1997, Mr. Baker says, they sold it for nearly $450,000 in May 2004. The couple now live in an apartment nearby, costing $2,250 a month in rent.

Since they sold, Mr. Baker concedes, the market value of his old condo probably has gone up even further. But he says he is happy with his decision. "Realistically," he says, "you're not going to be able to pick the exact top" of the market.


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