Someone asked whether there was a mechanism to hedge against the Australian housing market. There isn't .. but this article written by kris Sayce from Money Morning Australia .. considers whether there is a need to introduce a tradeable hedge.
"As mentioned in Friday's Money Morning, today's newsletter follows on in the same theme - the idea of a tradeable housing index.
An index which would allow investors to buy if they thought house prices were going up, and sell if they thought house prices were going down.
If it's done properly, a housing index could provide a useful purpose. Both as a measure of house prices but also as a way to bet on the performance of house prices.
That's the plus side. The down side of the idea is that the high price of housing could actually increase a person's risk exposure to housing. Or the capital required to enter the trade could be so prohibitive as to make it not worthwhile.
But let's look first at how a housing index could be created...
On Friday we wrote that a tradeable housing index that was based on theoretical values or fancy computer modelling would be doomed to failure. That's our opinion anyway.
We can't see how any serious investor would be interested in investing in something that was based on an opaque and unfathomable set of mathematical formulae.
So, what's the alternative?
As we see it, it's important to not try and reinvent the wheel. For all its faults, stock markets are still the most transparent market for trading there is. So therefore why not just copy the stockmarket model?
In the case of shares, most investors want to know a few key points. Chief among them is, what profit does the company make now, and what profit is it likely to make in the future?
Once you've run the numbers you can then figure out if the stock is currently trading at a discount, a premium or at fair value to its future profit potential.
So, is it possible to do the same with housing?
Of course it is.
But not with a fancy-pants computer model.
The simplest way to figure out the current and future value of housing is to use residential rental properties. The residential rental market provides all the figures you need to know about current and future profits.
A portfolio of rental properties provides the three vital ingredients you need: a purchase price, maintenance and financing costs, net rental income, and sale price (if the property is disposed of).
With all that information, not only would it be possible to monitor the increase or decrease in property values as properties are sold from the portfolio, but it would also give investors a genuine indication of the total income generated by the properties.
As you know, one of our biggest criticisms of property investing is that it's priced for perpetual growth, with no regard for how much income the property is generating - a classic sign that an asset class is trading in a bubble.
Just like the dot-com boom, and just like the US housing boom. Income was ignored simply because prices continued to rise, and the punters thought that would continue forever.
Residential property investors are happy to make a loss on their rental homes because they've been brainwashed into believing house prices can only ever go up.
But let's suppose this idea took on. Who would manage and monitor this portfolio of rental properties?
Well, there are two options. First is that property investors simply place their investments in a "managed portfolio", handing over administration of the properties to the property manager for a fee - not too dissimilar to how things work right now with real estate agents.
The second option is to rely on the data records of existing property managers, requiring them to provide purchase, sale and rental details for a random selection of properties they manage.
Either way, for the most part the data is already there. It's just a case of there being the will for someone to collect and maintain the records.
The benefit of this approach - while by no means perfect - is that the income generated from the rental properties would provide investors with an indicator of whether housing is undervalued or overvalued relative to the value of the underlying portfolio.
Sure, there would still be a degree of guesswork by investors, figuring out what the value of the underlying properties should be. But that's no different to the stock market.
The benefit that the rental index would have over the stock market is that properties are bought and sold all the time. If a property is sold from the portfolio, investors would be able to see how the sale price compares to the purchase price.
In other words you'd get a combination of growth and income data based on real prices and real rental incomes, rather than airy-fairy computer models.
Of course, it wouldn't be perfect. But no investment or index is perfect. Again, just look at the stock market for proof of that.
But that's the whole point of investing. Uncertainty is what drives prices in the market. Once you have complete certainty either way then you can guarantee that prices are ready for a reversal because they are either priced for perfection or priced for destruction.
And in reality, neither is likely.
The important point is that it would give investors a picture of comparative risks. Investors could easily compare the yield on a property index against that of a stockmarket index.
They could then figure out whether that's a yield worth investing in. Investors would then need to consider whether that makes it overpriced or not.
If they think so, then they can use the index to short-sell for profit, or to hedge an exposure.
Which brings us on to our other point. We've been told that one of the benefits of a housing index is that it would allow homeowners to hedge their housing exposure.
If they've bought a house worth $500,000 and they're worried the price could fall then they could short sell the index and neutralise their market position. They'd be protected against falling property prices, but because it's a hedge, they'd also miss out on any gains if prices continued to rise.
Right there you have your problem.
Quite frankly if you've bought a $500,000 house and you're worried the price could fall, then you've seriously got to consider whether paying that much for a house was a good idea in the first place.
You see, unless you're prepared to take a punt up to the supposed value of your house then it isn't a full hedge.
Is it really such a great idea that not only have the spruikers and banks and policy makers conspired to pump prices up to bubble proportions, that the some wonks are now encouraging people to take another punt on house prices in case they fall... to the tune of another half a million dollars.
Don't get me wrong, hedging a portfolio can be a great idea. It can help to protect your investments should something happen.
But do you really want to take a risk on short selling an index when you're betting against the most manipulated asset class in Australia? Would you really want to place a down bet when you know the government could come in to prop the housing market up with another billion or so dollars?
Sure, if you own a home then that intervention may have helped to support your house price.
But let's say house prices do go up. That means you're losing on your down bet. If it's a true hedge then as the price of the house increases your loss on the hedge also increases.
Imagine the irony if you'd hedged your $500,000 house at the beginning of 2009 only to see the index showing a 20% increase in house prices and then suddenly you're out of pocket by $100,000 on your bet... only to have to sell your house in order to cover the hedging loss!
You'd want to hope your house price had increased in line with the index in that scenario.
But even before that, how would you even place the bet? Would you have to stump up $500,000 in cash? Or would you do it on margin using a loan from, erm, a bank? Probably using your house as security.
From a hedging perspective the whole idea is getting smellier and smellier the more we think about it.
But the point is, as we've written many, many, many, times before, the ultimate use for a house is that it's somewhere for you to live. A house is a home not an investment. A house is a cost for an owner occupier, not a source of income.
Besides, if you're sensible then you'll have taken out building and contents insurance.
So do you really need to take out an insurance policy (hedging using a housing index) to insure against the value of your house falling?
Maybe you do. Certainly many homeowners in the US and UK probably wish they could have hedged their house price. But that's only because house prices were pushed up to such a crazy level - much as they have been here.
But as we see it, the creation of a housing index is the equivalent of a drug dealer giving his customers "downers" after spending years pumping them with "uppers."
The real cure is not to get the market high to begin with.
When all's said and done, regardless of what any potential housing index looks like, even if it's based on our idea, the reality is that anyone considering using a housing index to hedge the price of their house really shouldn't have spent that much on a house to begin with.
A housing index might be fun for a punt, but it won't prevent the housing market from crashing and it won't prevent overextended borrowers from losing not only their shirts, but their entire wardrobe as well."
