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Stock Strategist

Hedge Against the Looming Home Price Crash

The pros play interest rates to their favor, and so can you.

Alan Greenspan says home prices show signs of "froth." Yale economist Robert Shiller, author of "Irrational Exuberance," is predicting a massive correction in the housing market over the coming decade. A flood of major publications have highlighted this bubble with in-depth articles in recent weeks. I, too, in a column last month, compared the recent real estate boom to the dot-com bubble, and I also proposed a means by which investors could value their homes on a fundamental basis.

But, for all the talk of unsustainably high prices in the housing market, homeowners have done one of two things. They've either rationalized the ridiculous prices that homes fetch in some markets by pointing to trends like growing populations, limited housing stock, vacation home purchases by baby boomers, and a wave of 20- and 30-somethings buying condos in massive numbers. Or they've shrugged with indifference, believing that there's nothing they can do to insulate themselves if prices do plummet.

These are the wrong attitudes to take.

With some common-sense planning, investors (in this case, the 68% of Americans who own homes) can protect a fair amount of their true equity from a housing price crash. The first step is to quit buying into the hype. The demographic arguments that many homeowners and buyers are throwing around are all terrific long-range drivers that will affect the housing market over the next 20 years, but they certainly can't explain the whopping 51% run-up in national housing prices over the past 5 years.

Besides evidence of rampant speculation in some markets, there is only one fundamental, justifiable reason to explain skyrocketing home prices: Really low interest rates. And the neat thing about interest rates is that they can be made to sit up and dance for you. You can use them to protect the equity you have tied up in your home or investment property. The key is to borrow a page from the playbook of fixed-income investors, banks, insurers, and pension funds--all of which tend to be savvy players in making sure their equity doesn't vanish due to unpredictable swings in interest rates.

The Interplay of Rates
To protect the equity you have tied up in your home, you must first think of your home (or investment property) and the mortgage backing it as complementary financial instruments.

To fully comprehend this line of reasoning, we'll need to cover a few finance basics:

1) Interest rates and the price of fixed-rate bonds move inversely to one another; in other words, as interest rates rise, the value of fixed-rate bonds fall.

2) Your mortgage is a bond.

3) It's good for you when the mark-to-market value (as opposed to the book value) of your mortgage falls.

4) Real estate--while not exactly a fixed income security--behaves in a similar fashion to long-term bonds, moving inversely to interest rates.

5) Because real estate's value is linked to long-term interest rates--and it's possible to fund your purchase or ownership of real estate through a long-term mortgage also linked to long-term interest rates--it's possible to partially hedge against real estate losses.

What are the implications here? For starters, even if the housing bubble pops tomorrow for fundamental reasons (long-term rates shoot upward), you can protect much of the true value of your home equity, assuming you are capitalizing your home properly. Additionally, many borrowers--especially the fast-growing portion of the population with mortgages linked to short-term rates such as adjustable-rate mortgages and interest-only loans--are taking far more risk than they probably realize.

The Means to a Hedge
Matching a long-term asset like a home to a long-term liability like a fixed-rate mortgage makes intuitive sense. It's also no different than the strategies employed by many financial entities.

These investors (pension funds) and operating companies (banks and insurers) throw around terms like "duration" and "duration matching" straight out of fixed-income textbooks to describe what they're doing. At its most basic, duration is used to estimate how sensitive a financial instrument is to interest rates; in other words, how much will an investment rise or fall in value if interest rates shift by some amount, say 1 percentage point. Because rates are unpredictable, financial institutions don't want to see their equity wiped out by rate swings. Thus, they match their assets with liabilities that are similarly sensitive to interest rates so that both of these factors move up and down in value in lockstep.

Though the nuances of duration are complex--and large chunks of every fixed-income book ever written are devoted to this topic--there are only two points you need to know for our purposes. First, long-term investments fall and rise in value much more than short-term investments, given the same shift in interest rates. Second, variable-rate debt for all intents and purposes doesn't fall or rise in value at all.

So, now, ask yourself the question: If most financial institutions don't have the hubris to make big bets on interest-rate movements, why would homeowners? To minimize the risk of lost equity, real estate investors should currently be funding their homes with as long a term of debt as possible, likely a 30-year mortgage (unless you live in Japan, where 100-year mortgages have traditionally been available).

An Equity Squeeze
The best way to understand this is by working through an example or two. Here, I've tried to keep the math very simple. After building a duration spreadsheet and playing with it for nearly a full day, I realized that it's unnecessary for homeowners to do this work, because the end result was always the same: Take out a mortgage with as long a term as possible to hedge your downside.

Consider why. Let's start with a house purchased yesterday for $100,000 using a mortgage of $80,000. The debt is in the form of a 30-year fixed-rate mortgage carrying the current market rate of 5.2%, and the value of the property is based on a 5% real estate cap rate, the rate used to discount rental income in commercial property valuation. (If this latter number doesn't make sense to you, please read my earlier column on real estate valuation). Now let's assume that the property immediately falls in value by 25% (to $75,000) for reasons entirely related to market interest rates. This would equate to a rise of 1.7% in cap rates and long-term interest rates. However, because mortgage rates are also linked to these same market forces, we can assume that their rates also have risen by a corresponding amount. Because you now have a long-term mortgage locked in at a below-market rate, the mark-to-market value of the original $80,000 you borrowed has also fallen (a good thing) to about $67,000*. Your net equity has shrunk from $20,000 ($100,000 - $80,000) to about $8,000 ($75,000 - $67,000), but it hasn't evaporated entirely.

Now, had you funded the purchase of this house using an adjustable-rate or interest-only mortgage--neither of which changes in value with long-term rates because the rate on the mortgage automatically ticks up with rates--the mark-to-market value of your equity would have fallen to zero (or less). Your home would have fallen in value without any corresponding benefit from the mortgage.

This interrelation between property values and the hidden value of fixed-rate mortgages is likely the root logic behind the old Realtor adage: "Home prices never fall. Houses just stop selling." After all, while a homeowner might be willing to sell his house if it ticks down in value, the double whammy of also giving up the long-term mortgage locked in at below-market rates might be too much to bear. In those cases, even if you want to move to a new house, it's better to also hold onto the old house, renting it out for awhile, to continue to prosper from the cheap, below-market mortgage. This also is a good way, in my opinion, to prosper once the current housing bubble bursts.

Granted, property prices don't usually correct in such a dramatic fashion, instead trending up or down over a multiyear horizon. But the outcome doesn't differ substantially. If we assume a long, drawn-out housing price correction, some homeowners will end up in the same place, with their equity wiped out. For instance, according to Barron's, Shiller believes a 50% housing price drop (in real terms, not nominal) is possible over the coming decade.

No Perfect Hedge
Is my proposed hedge a perfect solution? Hardly. But there really isn't a perfect way to hedge the value of a home. For starters, it's impossible to obtain a mortgage that is long-term enough to match the characteristics of your house, which presumably will be there forever. Additionally, swings in long-term mortgage rates don't correlate perfectly to real estate; the cap rate on real estate and the interest rate on long-term mortgages don't go up and down in perfect lockstep.

However, judging by the data that I look at, homebuyers are using poor judgment in the instruments they're choosing to fund their houses. Not only are they taking on undue price risk--based on the amount they're shelling out for homes--in some hot markets, but they're compounding their mistake by using exactly the wrong type of mortgage for a low-interest-rate environment. In 2004, for instance, an estimated one fourth of all loans originated were interest-only, according to a report from the Joint Center for Housing Studies of Harvard University. These loans are almost invariably adjustable-rate, and nonprime mortgage players tend to allow borrowers to structure the total monthly real-estate payments (interest, property taxes, mortgage insurance, and so forth) equal to up to 50% of their pretax monthly income. This is on top of the movement toward adjustable-rate loans, with ARMs doubling their total market share in 2004 from the prior year.

What does all this mean? New homebuyers and existing homeowners (yes, much of this is coming about as a result of refinancing) are compounding their mistakes. Not only are they paying steep prices for their homes--caused at least partly by low interest rates--but they're also missing out on taking advantage of the low interest rates through their mortgage to hedge their downside.

Why is this happening? Because people view it as more "affordable" to have an interest-only or adjustable-rate mortgage. The real problem with this logic, though, is that if you can't "afford" to buy a home without a mortgage of this type, then you also can't afford not to hedge against the risk of loss--should home prices collapse.

* Footnote:
For simplicity's sake, I valued the mortgages using simple amortizing bond formulas, ignoring the tax deductibility of mortgage interest as well as the value of the option homeowners retain to prepay their mortgage at any time.