Investment is a hedge on 10 cities' markets

Starting next year, investors will be able to bet on whether housing prices in San Diego and nine other cities will continue to rise or plunge off a cliff.



The Chicago Mercantile Exchange, a leading futures market, plans to begin home-price trading in April. Investors will be able to buy contracts on the future direction of housing prices in the 10 cities, similar to what investors do now with oil or corn.



Trading places

The 10 cities that will be listed as part of the Chicago Mercantile Exchange's home-price trading futures in April:



San Diego



Los Angeles



San Francisco



Las Vegas



Boston



Chicago



Denver



Miami



New York



Washington





The investment vehicles are designed as a hedge against the risk in cities where home prices tend to be volatile. They will be based on median price indexes designed to represent movements in home-price values for each city.



While some economists question whether a home-price derivative market will gain traction, the fact that the Chicago Mercantile Exchange would launch such products could signal a growing concern about the nation's housing boom.



San Diego ranked second nationally among cities most likely to see housing price declines in the next two years, according to a survey from PMI, a mortgage insurance provider based in the Bay Area.



But the company only puts the odds of price declines in San Diego at roughly 50-50. And it doesn't specify whether prices will dive or dip slightly.



Hence, the potential demand for a home-price derivative market.



The derivatives aren't being tailored to individual homeowners. Instead, they target home builders, banks and large mortgage institutions that own bundles of home loans.



"It's a good idea – not for you and me – but it will be a risk-sharing tool for home builders and potentially some large real estate investors," said Stefan Meierhofer, a partner in A&M Investment Management in San Diego.



Still, homeowners could tap into the high-risk investment vehicles if they chose to.



The concept of real estate derivatives has been discussed since the early 1990s, but it took a boom in housing prices to propel it to reality. This will be the first time such a market is available.



Home values appreciated 65 percent nationwide from 2000 to 2004 and more than doubled in some areas, according to the National Association of Realtors. In San Diego, they've increased more than 140 percent in the past decade. U.S. residential real estate was valued at $18.6 trillion at the end of last year.



"There really is no way (now) for anyone to hedge home prices," said CEO Sam Masucci of Macro Securities Research, a Morristown, N.J.-based financial research firm that's developing the contracts with the Chicago Mercantile Exchange. "Or for institutional investors to gain exposure to the market without going out and buying homes.



"Housing is one of the largest asset classes in the world, (and) we thought it made a lot of sense to give people access to it," he said. "One never knows when you launch something like this, whether it's going to be successful or bomb. But all the elements are there for it to be successful."



Housing derivatives would work in a similar way to futures contracts. Say an investor thought prices would rise in San Diego. He or she would buy a futures contract based on the median price index for the city. If prices rise within the contract time frame, the value of the contract increases.



But say an investor believed prices would fall. He or she would buy versions of contracts called put options. These options typically cost several thousand dollars. They allow holders to sell their contracts at a gain if the price drops, ensuring that they recoup some of their lost house profits in a declining market.





The housing derivatives market would differ from traditional commodity futures, where a product, say oil or corn, is eventually delivered. With this market, investors would be betting on the direction of the median price index without ever taking possession of a house. The contracts instead would be settled in cash based on the value of the index.



"If you owned an expensive home and thought values were going to drop 40 percent – you'd say 40 percent of $800,000 is quite a bit," said James Barth, an economist and senior fellow at the Milken Institute in Santa Monica. "So you'd buy a put option where basically when the house went down in value, the put option would go up in value and you wouldn't lose much of anything."



Besides San Diego, other cities in the derivatives market are Los Angeles, San Francisco, Las Vegas, Boston, Chicago, Denver, Miami, New York and Washington. Investors also can buy based on a composite index of the 10 cities.



The real estate research firm Fiserv Case Shiller Weiss Inc. is involved in the project, developing the median price indexes for the 10 cities. Robert Shiller and Karl Case are leading real estate economists, Barth said.



"That tells you this isn't to be taken as a trivial exercise," he said. "These are very solid people with stellar reputations."



Still, many new financial instruments fail, Barth noted. If too many investors bet housing prices will fall, for example, the market becomes lopsided and tends to collapse.



Although some housing markets are volatile, particularly on the East Coast and West Coast, housing overall has been a good long-term investment, Barth said. So homeowners and investors may shun a hedging strategy.



"They may say, 'Yeah, values are going to go down, but if I'm going to stay in the home, I don't need to worry about that downside risk because in three or four or five years, they'll be back up again. So why hedge?' " Barth said.



Moreover, the median price index may not be accurate enough to help many homeowners reduce their risk. If prices for $1 million homes were falling, yet prices for more affordable homes were rising, the median would tend to reflect rising prices. So investing in median-based derivatives would provide no benefit to luxury homeowners.



"My initial gut reaction is the median would not be a very good read on the market," said Elaine Worzala, a professor of real estate at the University of San Diego. "I don't think it's for individuals. The people who could use it are lenders who have a portfolio in real estate where they're trying to minimize risk."



She continued, "For investors, returns might be less, but you're not subject to that big negative, which is what you really want to avoid."



By Mike Freeman