Why would we choose synthetic market exposure over "real" real estate? Using the traded derivatives, we are not limited to our local market. For residential markets in the U.S., the CME Group has contract available for ten MSAs and a composite index. If you felt property values in the New York MSA were going to offer better growth than in the San Diego MSA, you would simply choose the New York contract. Future contracts are standardized, while buildings are unique based on location and/or structure. The quoted future contract price is the current market value. With physical property, we must negotiate with the seller to come to an agreed upon sales price. In the following sections, it will be shown that a synthetic market exposure can generate the same real estate returns without the hassle.
Flipping a house is a speculative investment. A speculator buys a house with the aim of selling it at a higher price in the near future. Either the home price appreciation is anticipated to come from increasing home prices in the market, or the investment property was purchased at a discount from neighboring homes. If successful, a profit is made.
Synthetic flipping is also a speculative investment; however, we are only taking on market risk. Utilizing S&P Case-Shiller Home Price Indices futures, speculators can capitalize from changes in real estate values. Instead of scouring the web and real estate listings looking for a specific house to buy, we look for traded markets where home values will move: up or down. With synthetic home flipping, we can make money in either a growing or falling housing market. We are not exposed to structural risk where a home needs more renovation than expected. Management risks of buying too high or spending too much on décor are also reduced. Finally, we are not concerned about schools or neighborhoods.
Before jumping into technical issues, let us illustrate how synthetic flipping could be done. Ted wants to get into the residential real estate market. He works in technology and feels that the San Francisco housing market will see some increases. All of his friends are getting new jobs in the region, and he feels the area is going to spawn another tech-boom. Only problem is that Ted lives in Orlando, Florida. He considered trying to flip homes in and around Orlando, but the area has been hard hit by the economy. Orlando is expecting a slow recovery. The action is out West. Even if travel was not an issue, Ted now faces another hurdle. The average home price in the San Francisco region is $800,000. He only has around $10,000 to invest with. Therefore, Ted will utilize synthetic flipping.
Ted finds a futures contract on CME Groups website for San Francisco that expires in a year, contract SFRG1 (San Francisco, February 2011). The S&P Case-Shiller index for San Francisco is at 135.81, while the contract is priced at 122.6. The contract is discounted by 11% indicating the market feels the index will decline, whereas Ted anticipates improvement. Noticing this, Ted digs more into housing values and sales for the region. After a bit more research, he feels confident that there will be some growth. If nothing else, he does not see the market dropping 11%. Ted calls his broker to take a long position. The SFRG1 contract size is 122.6 x $250 = $33,952. In order to make the trade the exchange requires that Ted post a bond of $2,025, which he does with his broker. The broker explains to Ted that if the contract value falls to around 100 he would get a margin call and would need to deposit more money. With the contract priced less than 100, the performance bond of $2,025 would be worth less than $1,500: the maintenance margin of the exchange. Feeling confident, Ted executes the trade. Unfortunately, we find he was wrong about the market. The housing index for San Francisco fell 8% to 124.9 from 135.81; however, the market had mispriced the future contract that settled at 124.9 from 122.6. From the contract settlement, Ted receives the difference between his contract price and the settlement price. His return on the trade is (124.9 - 122.6) x $250 = $575. After including round trip brokerage fees he is left with $548 for a return on investment of 27% on the $2,025 at risk.
If Ted had anticipated the San Francisco Index to fall lower than the futures price, he would take a short position. Taking a short position in the future contract is not the same as shorting stock. A broker does not deposit a large sum of money into our account as if we sold the contract. Instead, Ted deposits his performance bond of $2,025 and his contract obligates him to sell a contract at a certain price level at expiration, or close it by purchasing a long position in the same contract. To illustrate, the San Francisco home price index is at 135.81. The bid price for the short position on a contract is low around 119. In order to make a profit the home pricing index would need to fall over 12%. This drop is higher than what is implied for a long position. Ted is cautious and double checks his research - San Francisco is in for a dramatic price decrease (he feels). He gets with his broker and executes a short contract position. Shortly after, his estimates of San Francisco home values prove correct. The home price index plummets; however, Ted still has a couple months left on the contract. Knowing when to take the money and run, he wants to take his profits by unwinding his position. To exit, he needs to purchase an opposing position for the same contract. A long position is available at 110 and Ted takes it. Because he has already posted a performance bond and is closing his position, the exchange does not require another deposit. The clearinghouse will match up his trades then clear and remove the positions. How did he do? For this trade his profit was (119 - 100) x $250 = $2,250. After fees, he earned around $2,220.
For a quick comparison, imagine he had purchased a physical property in San Francisco. He cannot afford the average $800,000 home so he finds a good deal on a studio for a sales price of $450,000. Somehow, he found $45,000 for the deposit. To entice Ted to buy the unit, the owner even paid the sales and closing costs. The location is good, and Ted feels he can sell it to some young IT professionals. For the example, suppose the condominium also lost 8% in value from the sale. Now, the S&P Case-Shiller Home Price index does not include condominiums, only repeat sales of single-family homes. Therefore, the decrease in value of the unit would generally not match the index, but condominiums can be more sensitive to the market. How did he do? Well with the decrease in value, the unit is now worth $414,000. If a buyer could be located, Ted would still need to pay some closing costs and a broker's fee. Each month a buyer is not located, Ted will pay an additional mortgage payment, utilities, and association fees. He may end up losing most of his deposit. Unlike a synthetic position, it is not possible to make money on physical residential properties when their values are decreasing.
Understanding that our example is not perfect, it does illustrate how standardization of future contracts makes life a bit easier. In futures, the price and "quality" are already known. Real estate has a wide range of prices and "quality". In order to get into the market with a physical asset, Ted had to compromise based on his ability to invest. Futures contracts are sized in smaller increments. The condominium unit at $450,000 would equate to roughly thirteen future contracts. Because of the smaller increments, Ted can deploy his investment capital more effectively. Suppose his research pointed to a rise in New York real estate prices. With the money sitting in the account he could take a position in New York home prices while keeping his contract in San Francisco. With physical assets, he would need to find additional cash and financing for around $300,000 for another small unit. In addition, he would now be floating $750,000 in debt if he could get the financing.
Now that we have seen an application of synthetic flipping and its advantages, let us look review the components of trading. First, the CME housing future contracts are limited to ten major MSA's and a composite weighted index of those MSA's. Although it may seem limiting at first, it becomes apparent that the indices do a good job of covering different regions of the country. Each MSA has different strengths and weaknesses, enough to keep it interesting. In the first part of the book, we reviewed home and property values. Putting the knowledge to work and conducting further research, we need to determine which of the ten MSA's has the best prospects for price movement - up or down. Econometric models on each region should be reviewed, which you can find on the web from venders, researchers, and associations. We are looking for employment, population, and income projections. Also, verify the average days on the market and inventory for home sales. If the days on the market and inventory are over three months, it could indicate a buyer's market. S&P/Case-Shiller Home Price Indices can be downloaded free at Standard & Poor's website. Once we feel comfortable with our research on a few MSA's, we can look at the future contracts. If that seems overwhelming, you can focus on just your favorite.
The future contracts can be viewed free at the CME Group website under the S&P Case-Shiller Home Price Indices. Once on the pricing web pages, each contract can be viewed. The Contract Overview shows the expiration of the contract, symbol, and last price. In the next column we have the outrights, our main interest. Outright literally means to buy the contract "outright". Listed are the bid size, bid price, ask price, and ask size. The bid/ask size refers to the number of contracts available. The bid price is what someone is willing to pay for the contract, while the ask price is what someone will charge for it. Generally there is a gap between the bid/ask price which may include a premium. Next to the outrights is pricing for inter-market spreads and intra-market (calendar) spreads that we will cover later.
From the different contracts prices, we can see where the market is implying home index values to be at the contract expiration. Our task is to see if we agree with the implied prices based on our research. If we feel prices will be lower, we go short the contract based on the bid price - make sure you intend the index to go below what you pay, not the last bid price. If we feel prices are going up, we go long a contract based on the ask price. One issue we could run into is that there may be no trading in a particular contract. The market is still new, so trading in real estate futures is in its nascent stage. As the market grows and matures, we should see an improvement.
Before we can trade, we need to open a trading account with a brokerage firm and learn a few basics in future trading. Pending everything checks out and we are familiar with the ordering and selling processes, we can begin trading. As mentioned earlier, the future contract size is valued at $250 times the index. When purchasing futures we do not technically pay up front for the trade, we place a performance bond. The amount of the bond can be found on the CME Group website, and is roughly 6% of the contract value at the time of writing. Similar to real property, the futures utilize leverage for superior returns. Back on the CME Group webpage, we can find the maintenance margin. Listed under maintenance, the value represents how low your performance bond can be valued based on the contract prior to getting a margin call from your broker. Speaking of broker, we need to verify the brokerage fees so we can accurately calculate where the property index needs to pass so we can make a profit. Because the futures are marked to market, each day of trading our account will be credited or debited based on the daily closing contract price.
To close out our position prior to the contract expiration we need to offset our current position. If we had purchased four contracts that were long on San Francisco, to close the position we would purchase four short positions on the same contract. If we are short a contact, we would need to purchase a long position on the same contract. The exchange would then net out our positions and settle the cash due. If we choose to leave our position open until expiration, the contracts would be settled by the exchange based on the position and difference in our contract value and the underlying index.
Earlier we had seen pricing for intra-market (calendar) and inter-market spreads on the CME Group website. Calendar spreads are taking positions in the same contract with different dates. Inter-market spreads are taking positions between different index futures; the price spread between Boston and Chicago contracts. We could use outrights to construct our own spreads, but the traded spreads require a smaller performance bond. Let us use Ted one last time.
Ted exited his prior synthetic flip with a profit. Through some further research and conversations with some friends in Washington, D.C., he feels the residential property values there will grow in a few months. His friend who works at a federal agency has explained how the government was going to expand, again. This trade Ted wants to utilize a calendar spread. Currently the S&P Case-Shiller Home Price Index for Washington, D.C. is at 179.1 as published in December 2009 (remember the index level published is lagging 2 months - the index level is for data through October 2009). The calendar spread that Ted is considering is for the February 2010 (WDCG0 @ 170, the front) and May 2010 (WDCK0 @ 165, the out) Washington D.C. contracts; the symbol is WEDG0-WDCK0. For the spread, the asking is priced at 20 for a long position, while the bid is at (-18) for a short position, (a negative price only means the out contract must be less than the front by 18). Ted is bullish so he goes long on the spread paying the asking price of 20. For the spread, the performance bond is only $878 with a maintenance margin requirement of $650. He now has two positions, a long position in the front contract (WDCG0) and a short position in the out (WDCK0). February rolls along and the front contract expires at the index level of 176. Ted has made a six point profit on the long leg, front. Unwinding the short leg, the out, he is able to purchase an opposing forward position in the WDCK0 contract for 162. On the short leg, he picked up another 3 points. All together Ted has been able to generate a nine-point return, too bad he paid 20 for it. His losses total (20 - 9) x $250 = $2,750. The effects of leverage are easy to see in spreads, but it works to magnify gains and losses. If he had purchased a spread that was reasonably priced, his outcome may have been a superior gain compared to outrights.
Finally, we can offer contracts to trade on the exchange by naming the quantity and price you are willing to trade. There is no guarantee anyone will take the trade, but it allows us the ability to customize contracts - in theory.
This section is to illustrate how property derivatives utilized with other financial instruments can mimic the financial performance of an income-producing asset: synthetic income property. As with any representative construct, it will never match the original perfectly. Since only residential home price futures are available for small investors, we are again limited to the ten MSA's plus the composite index. As future markets develop, we would hope for commercial property index futures in order to allow us straight synthetic exposure to develop better commercial synthetic constructs.
In general, the returns on residential rental property are composed of rental income and a capital gain from the sale of the property. The rental income after taxes and debt service is generally two percent of the total project costs, and around ten percent of the invested equity - both after taxes. In order to receive the ten percent of equity in potential rent, the investor needs to carry a high loan to value mortgage, a significant risk. The value of a property future is a bit difficult to estimate. At expiration, the futures are settled based on the difference between the underlying index and the contracts position and price. To take a future position, a performance bond must be posted. If the value of the bond were reduced, we would receive a margin call to recapitalize the bond. If the bond is not capitalized, the exchange can liquidate the position. Therefore, to compare "apples to apples" we will consider the performance bond as part of the total costs similar to a mortgage. Both the bond and mortgage are obligations. The capital gain in the property is the difference in value of the property's purchase and sales price. To build our synthetic income property we will need to replicate both the rental income returns and capital value.
First off, we need to determine how large an investment we would like to make. Next, we need to determine which MSA to place our synthetic property. Similar to synthetic flipping, we are really looking for contracts that will provide price movement. It does not matter if the index is rising or falling, we can make value gains with either direction. Although the S&P Case-Shiller Home Price Indices exclude apartments, the movement in the index is highly correlated to the NCRIEF apartment index. The S&P Case-Shiller will provide us with the ability to capitalize on real property value movement that we need. Finally, an investment that produces at least a two percent return would need to be located. There are an endless number of possibilities for the synthetic "rent". Depending on the world's financial condition, we can choose from dividend paying stocks, money market accounts, bonds, etc. It would be wise to consult with a licensed broker to make sure the investment is expected to perform close to our synthetic rent return requirements. Like a property owner, we will need to monitor our investment to make sure it is performing. Instead of evicting a bad tenant who does not pay rent, we change the income producing investment. Let us jump into an example.
For the example, we are going to construct a synthetic apartment building in the New York MSA. Our research has indicated that the Big Apple is ready for resurgence. To be flexible we will keep the contract lengths to no more than a year. We will look at outright contracts and spreads. Currently the S&P Case-Shiller Home Price Index for New York is at 175.01. Since we are anticipating property values to increase, we will review the forward positions on the CME Group website for New York housing futures. The contract nearest to expiration is February 2010 priced at 173.2. The next contracts are price as follows: May 175.0, August 174.0, November 174.0, February (2011) 162.00. If we consider the contract prices as what the market implies the value of New York housing levels will be, it seems a gradual decline has been priced in the contracts. Either we have unique knowledge or our estimations are off. Back to study our data. We are going to forge ahead with the expectation that housing values will increase this year. Not being able to get a trade on the 2011, we will purchase the August at 174.0 and keep rolling our position as long as we wish to keep the synthetic apartment in play. To enter the long position on the August contract we need to supply a performance bond of $1,688 per the exchange that is done through a broker.
Our synthetic yearly rent requirements are two percent of the total investment. This simulates the cash to the owner after taxes and debt service. We would prefer to keep this portion of the synthetic construct liquid. For practical purposes, we may only be able to collect our income yearly depending on the tax issues of the investment. Our broker has found a municipal bond mutual fund that has been generating six percent returns consistently. To determine our additional equity contribution to make the rent hurdle will require some simple algebra.
(Total Investment) 2%=6% (X)
We may need to round-up in order to trade, but the $844 investment into the mutual fund will meet our requirements.
For $2532 plus some small fees, we have created a synthetic apartment with exposure to New York residential property values. Think of our construct at one synthetic unit. Depending on our risk appetite and investment capital, we could increase the number of units. How do we compare to the real world. At the time of writing, a nine-unit apartment building in Harlem was listed for $1,100,000 with a net operating income of $82,184. If we could obtain a 90% loan to value loan at six percent interest with a thirty-year amortization, the yearly payments would equal $71,220. The cash left over to disperse to the owner is $10,964. The ratio of the cash to total expenses is roughly 1%. Had we run a full analysis to include building depreciation we would probably see the cash to expense ratio closer to 2%.
The synthetic is by no means perfect. Again, this exercise was to demonstrate that we could construct synthetic income property to mimic real property. When a physical real estate investment is broken down to its basic components, we are left with a cash flow and capital value component. This is what we synthesize.