A friend sent me this...any real estate experts want to address?
1. Current U.S. residential real estate prices are egregiously inflated
in the context of historical norms. The housing bubble is a result of
the abundance of capital provided to the marketplace at historically
low interest rates in conjunction with the easy money policy of an overly
dovish Federal Reserve Board. The current rate of inflation exceeds the
risk free rate of return by approximately 360 basis points. The
current environment of negative real rates of return is a state of economic
disequilibrium that will reverse itself and trend toward a normal
environment of positive real rates of return. This is most likely to occur
when the bond vigilantes declare “no mas”, and it no longer suits
foreign creditor’s interests to subsidize America’s trillion dollar fiscal
and current account deficits. The current account deficit has already
broached 5% of GDP which has been the historical barometer of impending
structural change.
2. The GSEs (Fannie/Freddie) as well as other traditional lending
institutions have facilitated the buildup of a housing bubble by increasing
the pool of potential home buyers, lowering credit quality standards
and tolerating questionable appraisal standards. The unprecedented yield
spreads and an effort to increase the GSE’s earnings have exacerbated
the situation and provided the motivation to accept lower credit quality
and questionable appraisals in exchange for higher margins and volume.
The increased volume has led to the GSE’s retaining large amounts of
mortgage backed investments and the massive buildup of derivative
transactions designed to shift their interest rate risk. The questionable
status of whether or not the counter-parties to these derivative
transactions have adequate capital to offset such losses as well as the
in-adequate hedging methods employed add to the prospects for potential
disaster. These conditions have further artificially increased the pool of
liquidity and substantially raised the risk of a near term real estate
collapse.
3. An unprecedented increase in money supply aggregates partially a
result of refinancing activities has added additional fuel to the housing
market bubble causing it to inflate at an unsustainable rate.
4. A homeowner has the potential for an increase or decrease in the
value of real estate (capital appreciation or loss) that is magnified by
the potential leverage that may be employed. Real estate provides
tremendous leverage through the ability to borrow at current market rates
with little or no equity in the underlying asset. The homeowner is
speculating that the current market value of the property will appreciate at
a rate that exceeds the current cost of capital and inflation over the
holding period of the investment. In many U.S. households, the primary
residence has traditionally been the largest single investment.
5. The value of real estate has a high correlation to rapid changes in
interest rates as well as the perceived future rate levels; whereby a
decrease or a perceived future reduction in interest rates increases
property values; an increase or perceived rising rate environment erodes
the current market value of residential real estate as cost of capital
increases reducing the pool of new homebuyers. In a high rate
environment, economic activity is choked off creating additional supply of homes
as the labor market constricts people can no longer afford to keep up
mortgage payments.
6. In a falling rate environment, an investor that has the ability to
access a cash-out refinance has virtually no interest rate or
reinvestment risk with respect to equity that has accumulated as it may be
refinanced and taken out at will as the property maintains or appreciates in
value. However, in a rising rate environment, the equity the investor
has accumulated is subjected to re-investment risk, market risk, and
liquidity risk. Real estate is an illiquid investment. As mortgage
rates rise, the pool of potential homebuyers shrinks further reducing
liquidity. An investor who has accumulated a significant amount of equity
in real estate faces the risk of a substantial capital loss.
7. A homeowner with equity has the ability to conduct a cash-out
refinance using a conventional 30 year mortgage at interest rates consistent
with current 30 year U.S. Government Bond Yields and incur minimal
transaction costs.
Hypothesis:
A homeowner who has equity in their property has a synthetic equivalent
position in an amount equal to their equity in 30 year U.S. Treasury
Bonds. By not implementing a cash-out re-financing, the investor is
speculating that interest rates (current value of money) will remain the
same or decrease and the property will maintain or increase in its value.
The investor is expecting the current market value of the property will
go up at a rate equal to or greater than current 30 year interest rates
plus the rate of inflation. An investor can hedge a potential
decrease in the current market value of their property without liquidating it
or initiating a cash-out re-financing by implementing a short hedge.
The investor can sell the synthetic equivalent bond position in the
futures market to offset a potential decrease in the value of property
brought about by higher costs of capital, and a subsequent potential
collapse in the housing bubble.
Example:
An investor owns $200,000 worth of residential real estate. Current
30yr mortgage rates are @ 5.66%, September 2004, 30 Year U.S. Government
Bond Futures are trading at 109 11/32 with a contract size of $100,000
and 1/32 ($31.25) Tick Size. Contract months (March, June, September,
and December).
Sell (2) September 2004, 30 Year U.S. Government Bond Futures @ 109
11/32
Initial Margin Requirement: $2,160 / Contract x 2 = $4,320
Maintenance Margin: $1,600 / Contract
Historical Volatility 30 Year US Treasury Bond (1980-2004)
3 Standard Dev. Low Price High Price Basis Points
Mean Variance 11 9.94 99.40625 119.28125 +/- 80 Basis Points
High Variance 28.6 16.04 93.31250 125.37500 +/- 131 Basis Points
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