The Money Mustache Community
Learning, Sharing, and Teaching => Investor Alley => Topic started by: danclarkie on November 17, 2014, 12:44:51 AM
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The classic advice stands that nothing is more dangerous than an investor who thinks he has a theory, so hopefully you can shed some light on what I am missing here.
An idea that has been kicking around my had for a while is that an investor who is in rented accommodation might be able to hedge against rental increase by using REIT future call options.
I wrote an article on it that covers it in more detail: Hedging Rental Increases with REIT Options (http://expatfinance.net/hedging-rental-increases-with-reit-options)
But the basic premise is:
Assumtions:
- Rental price is floating with no government caps or controls
- The rental price of your accommodation is tied to the property price
- The property price rises in line with all other property in the market
- A REIT can be found that covers the local property market only, and trades as an ETF
- There is a market for trading future options on the REIT
- Trade commissions are, essentially, negligible
Essentially, if all of the above is true, an individual could hedge against the rental price next year by buying call options on the local property market REIT.
i.e
- My rent this year is $20,000
- REIT tracking my country alone, trades at $20/share
- Purchase call options on 1,000 shares, with an expiration date of 1 year from today, with a strike price of $20.
- Premium on the call is $X
- If the property market grows by Y%, the rent due should grow by Y% but so should the REIT.
- 1 year from today I exercise the call option and take profit of ($20,000 * Y%) - $X
- This essentially caps my rental increase at $X, since anything above that is offset by the REIT option profits.
- If the property price falls, by rent is the new rent price + $X
Provided at the time of initiating the contract, $X is a fair value in my opinion, I can essentially cap any rental increase for next year and not leave my rent at the mercy of the open market.
Is the theory here correct?
Or am I missing something stupid?
Cheers.
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- A REIT can be found that covers the local property market only, and trades as an ETF
They have REITs that cover individual neighborhoods?
I guess a REIT could be started for a single 300 unit apartment building, and if you lived in that building you could use this strategy.
Otherwise, no.
What if that REIT owns more buildings across the country, and those fall in value? Suddenly your rent is rising as the REIT price is falling.
Even if your REIT only held the one building, you're assuming the market is perfectly efficient - i.e. the REIT value is 100% directed by the current income. However it's been shown that REITs tend to track the market. So market falls, REITs fall too. Your rent could be increasing though, as the stock market overall is falling.
Basically you're assuming they're perfectly inversely correlated. They aren't.
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Yeah I guess the main flaw is that the market is not totally efficient and the two are not 100% covariant so this will never be a perfect strategy.
But as a general hedge (say 70% or so covariance), and as a theory only, does it not work?
They have REITs that cover individual neighborhoods?
Neighbourhoods no, but countires yes.
If you live in a small enough country (UAE, Hong Kong, etc) the correlation would be higher, plus I would blindly assume that REITs, for the most part, hold property in urban areas not rural countryside, which should increase the correlation if you also live in a city.
What if that REIT owns more buildings across the country, and those fall in value? Suddenly your rent is rising as the REIT price is falling.
Even if your REIT only held the one building, you're assuming the market is perfectly efficient - i.e. the REIT value is 100% directed by the current income. However it's been shown that REITs tend to track the market. So market falls, REITs fall too. Your rent could be increasing though, as the stock market overall is falling.
I suppose the hedge is more against the systematic risk of rising prices, rather than the unsystematic individual properties.
Ah well, was mostly just a thought exercise that I hoped to try and stir up some discussion around.
I think it's cool to consider using financial tools such as derivatives and future options to hedge against real world costs of stuff, it helps understand a connection between Wall Street and Main Street.
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They have REITs that cover individual neighborhoods?
Neighbourhoods no, but countires yes.
If you live in a small enough country (UAE, Hong Kong, etc) the correlation would be higher, plus I would blindly assume that REITs, for the most part, hold property in urban areas not rural countryside, which should increase the correlation if you also live in a city.
That was my point with the tongue-in-cheek question; real estate is local, typically REITs aren't.
Covering an entire country and hoping that correlates perfectly to your one small building or neighborhood seems like a huge stretch.