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6 Ways to Profit from the Housing Bubble Bursting:

September 19, 2005

 

We seem to hear about it in one form or another daily. Whether it is new home sales figures on CNBC, a friend of a friend who just made $500K on a house in Ft. Lauderdale, your neighbor quitting his school teacher job to become a real estate broker, and so on. Real estate is the new national pastime in the United States.

But for every twenty people who state emphatically that real estate "Can't go Down", there are a few of us out there who think this looks an awful lot like a housing bubble. There's the interesting question of whether there can be a housing bubble if it is already recognized as one, but it sure seems like a bubble when a small 2,000 sq ft. two bedroom condo in the new Trump Towers in Chicago is selling for more than $1,000 per sq. ft. That's $1 Million per bedroom!!! Where are the people who can afford that coming from? Are they lawyers, doctors, Saudi princes? If you go by semi-conservative standards and try and keep housing costs at less than 33% of your gross monthly income - these people should be making about $750K/yr - a level less than ½ of 1% earn in this country.

So if you think it's a bubble - and if you think its only a matter of time before it bursts - what can you do to profit from this bubble? Unfortunately, this isn't as easy as the internet/tech stock bubble, where those who saw the end was near could simply sell short the way overpriced stocks, sell short the QQQs, or better yet - sell some Nasdaq futures.

But shorting the real estate bubble is not so straight forward. There's no real-estate futures, unfortunately. We think it would be a phenomenal product for the CME to launch - but they have been slow to adopt our ideas. (After writing this line sometime last week - the Wall Street Journal actually reported this weekend that the CME is set to launch Real Estate futures for 10 major cities in the United States - as well as a contract on the composite of the 10 cities - in the 2nd quarter of 2006. Finally, the ability to system trade real estate)

The most likely scenario for a big time housing bubble burst is a rising rate environment where the prevalence of adjustable rate mortgages balloon into huge monthly payments. Without trying to scare anyone, I'll point out that we are IN a rising interest rate environment right now. The prime rate in the US has risen 63% since July of 2004, moving from 4.00% to 6.50%, making it more an more likely that John and Susie Q homeowner won't be able to pay their adjustable rate mortgage any longer.

In a worst case scenario, after the 3, 5, or 7 year ARM (adjustable rate mortgage) starts "adjusting" over the next couple of years, many people's monthly payments will increase substantially (possibly around the same amount that the prime rate has risen) It could come down to people having to choose whether to eat and pay the heating bill, or pay the now increased monthly mortgage.

It's not too far of a reach to imagine a lot of people having to sell their house in order to get into something more reasonable with lower monthly payments. Now imagine that scenario played out over the course of two years in millions of households, and you can start to see the scary downside of housing bubble burst represents. With millions of people who used adjustable rate mortgages to lower their monthly payments having to sell in order to have enough money each month to live - the selling pressure will mount. As more people have to accept lower prices, the lower prices will go — until the downward effect is pronounced.

For all those who say that couldn't happen here, in the United States, the largest economy in the world, listen to the sad tale of the 2nd largest economy in the world - Japan - which has seen falling real estate prices for 14 years in a row as housing prices are down over 40% since 1991. Is it a coincidence that the Japanese Nikkei 225 stock index is down over 66% from its 1989 high and has lost nearly 50% since housing prices started falling in 1991?

..........................*Source: Economist.com

A further component that will effect all of the speculative "investing" is the realization that real estate returns aren't all that spectacular after all. Why is it real estate people always state their gains in dollars - while the rest of the investment world deals in annual percentages? A friend was bragging about their $100K gain over the past 4 years on a condo bought for $200 K. It sounds great to make six figures on something you were using nonstop for four years, but what is the real return there?

With approximately 6% in real estate fees on each side, and the majority of mortgage interest paid in the first five years, the actual gain was probably more like $70K - and the actual annual rate of return on this condo was therefore only about 9% per year….That sounds a lot more like a broing stock market investment than the "red hot" real estate market.

And what is everyone doing with their gains? Putting it in the bank? Diversifying into other investments? Not a chance — their buying bigger houses and taking on larger mortgages. I'm not convinced Buy high, Sell higher - Buy even Higher is a winning formula over the long term. I personally would prefer buy low, sell high, buy low, sell high - repeat as necessary.

But all of this begs the question — how can you profit from a housing bubble burst. Here's six possible ways to profit from a housing bubble burst.

1. Short the home-building stocks and/or REITS. Big homebuilders like Toll Brothers, Centex, Lennar, Pulte, KB Homes and more will surely take a hit should either the number of new home sales start to decline or the prices of those new homes start to decline. Combine this with rising prices for components like Cement, Lumber, and Copper (wiring, plumbing) - and you can start to see why many insiders at these companies have been selling some of their stock.

Beware - Some very smart and very rich investors have lost a lot of money shorting the home builders.

2. Short the aggressive mortgage lending companies. While we are not experts in this area, this sure seems like a great place to make some money should all of the adjustable rate mortgages and interest only loans blow up. More and more lenders are relying on these products to drive earnings, and those earnings will be very suspect should these products become heavily regulated or less popular due to the shrinking spreads between short and long interest rates. If the yield curve continues to flatten, or even inverts - a 5 year ARM and 30 yr mortgage may end having nearly the same rate - at which point you would have to ask why take on the risk of the adjustable rate?

3. Short the whole US stock market. With reports of housing making up nearly 15% of United States GDP, it seems a good bet that the bubble bursting would have ripples throughout the economy. The chief target would be the US consumer, whose spending represents roughly 75% of US GDP. Will the consumer have as much bite if their home is worth 20% to 30% less - I wouldn't bet on it. Consider the Japanese stock market has lost nearly 50% of its value since 1991 - when housing prices began their 14 straight years of declines.

The easiest way to short the whole US stock market is selling an S&P future or e-Mini S&P future. Nasdaq futures and/or Russell futures could also work, but could be less correlated. All of the stock index futures work just like the better known QQQs and SPDRs, but have much better tax treatment.

4. Go long Gold. We are usually not proponents of Gold, as it has little to no real economic value, but Gold could increase smartly should the housing bubble burst and take the US economy and US Dollar down with it. The best way to get long gold exposure is through gold futures. Buying Gold company stocks means your going long gold, and the management, and their mining operations, and the stock market, etc. Gold futures mean you are long gold, and gold only. One warning here - Gold is currently sitting at 15 year highs in response to the inflation fears brought on by record high energy prices.

5. Short the basic commodities. A slowdown in housing demand will lead to a lot of oversupply of houses - there's already evidence of oversupply - which could mean a reduction in new home starts. With less new homes being built in order to work off the existing inventory glut (remember a big part of the tech bubble bursting was due to an inventory glut), the demand for basic commodities like Lumber and Copper will decline. Assuming normal economics are working, once the demand starts to decline, so will the prices. One warning, Lumber futures are very thinly traded, and very volatile - meaning only the very bravest and well capitalized should consider this approach.

6. Short Real Estate Futures. OK - I'm jumping ahead here, there's no such thing just yet. But news out of the Chicago mercantile Exchange is that they will be launching real estate futures in the 2nd quarter of 2006. Whether the Fannie Mae's, Freddie Mac's, hedge funds, and individual investors will use the risk transfer properties futures contracts provide to lay off some of the risk each has to declining home prices remains to be seen. There is also the little problem that a whole city's prices could be rising, while your little neighborhood is declining in value, so it will never be a perfect hedge against the price of your home, but its still a lot better than having no option to hedge at all.

For a sneak peek of what the CME's real estate futures might look like, check out www.hedgestreet.com and look at their housing price hedgelets. These are essentially futures contracts that appreciate or decline in value leading up to the quarterly report on average housing prices in Chicago, Los Angeles, New York, San Francisco, San Diego, and Miami. This is a great idea, but the volume is very, very low, and you would have to do quite a bit of volume to hedge a home of any significant value.

 

-Jeff Malec